Accounting Differences Between Arizona Rent Tax and Sales Tax

Background

Earlier this year, the financials for one of my office properties in Arizona caught my attention. We recently changed management companies, so I expected certain challenges in getting reporting straightened out. However, the differences were large enough to prevent us from being able to cleanly reconcile what we track internally against what was prepared.

Although on the surface it appeared we were using the same conventions, we still remained a small fraction apart. The clue was in an account that coincidentally appeared which hadn't been on any reports earlier and we tend not to see in the state of Arizona, Sales Tax Payable. From seeing this account, it was immediately clear what had happened. The management company was treating Arizona transaction privilege tax as sales tax.

What's the difference?

Sales tax is collected by the vendor at the point of sale on behalf of a taxing authority, and the remitted at some future date by the vendor to the authority.

Consider a point of sale cash transaction for a sale worth $100 with sales tax of 10%.

Then at a later date, the vendor pays the sales tax.

In Arizona, on the other hand, you have privilege tax that's the obligation of the vendor rather than the customer. This is the principal difference and is based upon how the tax law reads. This article is a discussion on Arizona Transaction Privilege Tax and specifically how it applies to commercial leases and commercial real estate operations.

Arizona Rent Tax is not Sales Tax

Arizona rent tax (Transaction Privilege Tax) isn't sales tax in the way we commonly use the term. "Sales tax" is often used in circumstances where upon a sale a tax obligation belonging to the purchaser/customer is created However, in many cases the vendor collects the sales tax and pays it on behalf of the consumer.

It's often the vendor's performance obligation to collect and deliver the tax, but it's not their financial burden. This is often the case for simplicity. If consumers were required to track their own purchases and remit sales tax on their side, it probably wouldn't happen. But the fact remains that it's still the purchaser's obligation, hence why you're able to deduct it on your tax return (SALT deductions).

Arizona Rent Tax, also known as TPT is not this. It doesn't matter if you collect this amount from your tenants or not. It is still owed to the Arizona Department of Revenue (ADOR).

On the Arizona Department of Revenue's website, it mentions this reality out of the gate (as of November 20, 2023):

Although commonly referred to as a sales tax, the Arizona transaction privilege tax (TPT) is actually a tax on a vendor for the privilege of doing business in the state. Various business activities are subject to transaction privilege tax and must be licensed.

With this understanding, let's refactor the previous sale for $100 where the vendor includes the 10% tax levy in the total. First, the cash receipt and revenue are recorded.

Simultaneously, the obligation to the taxing authority is recorded.

With this convention, it's more clear who the obligation belongs to and therefore results in a more faithful representation of the activity that occurred.

Why Are The Amounts The Same?

The reason we have a tax of $10 here instead of $11 ($110 X 10%) deals with the specific language of the law.

[T]he total amount of gross income, gross receipts or gross proceeds of sales shall be deemed to be the amount received, exclusive of ... [t]he taxes imposed ...

A.R.S. 42-5002

So basically, while you're paying tax on the top line, the tax is itself a deduction. If it wasn't separated from the start, you can factor it (back it out) from the transaction. 

Why The Distinction Between Sales And Privilege Tax Matters

If you contract with your customers to collect from them an amount equal to the tax, it really doesn't from a practical standpoint. Over the long run, either method will arrive to the same conclusion: net sales of $100 and a tax paid of $10.

In the short-run, differences in accounting conventions (cash vs. accrual) can lead to inconsistencies. Rent is most often accrued on the first of each month. However, rent isn't always paid on the first of each month. TPT, however, is often reported and paid on a cash basis.

Practically within my businesses in Arizona, we factor tax on cash receipts regardless of whether a lease dictates that an amount equivalent to the tax is to be paid to the landlord and collected separately. As demonstrated earlier by the separate journal entries, these activities are independent to begin with. But more importantly, it's just easier when you have a property with many leases that you wouldn't want to track independently.

Let's say a tenant pays in the period following the accrual. We'll pay tax in a later period than the accrual. Alternatively, if a tenant prepays their rent, we're going to pay tax on rent that hasn't been accrued yet. If you were using the Sales Tax Payable account to accrue TPT, you now have a negative balance in a liability account. This isn't ideal for presentation.

End of Period T - 1

Beginning of Period T

Why wouldn't we report and pay tax on an accrual basis then? You could, but not every tenant pays their rent. And when they do, it's not always on time. Paying tax on accrual would effectively be prepaying the tax in anticipation of a future receipt. 

How We Treat TPT For Commercial Leases

We, like many other landlords, accrue rent on our commercial leases on the first of each month. The amount accrued will be inclusive of rent tax if it's in the body of the lease agreement that an equivalent amount is owed to the landlord.

Period T

Through the period, cash will be collected.

At the end of the period, the books are closed without paying the tax authority. Tax is payed in arrears. For TPT filed monthly, this is currently the 20th of each month following the period in which receipts were collected A.R.S 42-5014 (A)(1).

On the 1st of T + 1

On or before the 20th of T + 1

With this approach, we have books that faithfully represent what belongs to who and in what periods. Is this exactly how we operate? No. There's system constraints with the accounting software used depending on asset type, region, etc. But this is what we aim for.

Final Thoughts

My point with this article isn't that handling TPT is complicated, but instead the opposite. There isn't anything above the level of a first-year accounting student, barely exposed to concepts of financial accounts, journal entries, and a "T-Account." Yet still, I see educated accountants routinely get this wrong and defend their reasoning with poor arguments.

I see this as laziness, first and foremost. Having books well representing the realities of the transactions they're comprised of sometimes takes additional steps. This is especially true when the overly abstracted workflows of rigid accounting systems push accountants in certain directions. But that's not an excuse.

It's easy to fall into the trap of simply getting your job done and forgetting there's a bigger picture. Downstream users of the financials rely on accurate and faithfully represented reports. Deviations from this will affect decision quality.

It's also annoying. When we audit reports against what's tracked internally at the sponsor level, it can be burdensome to figure out why things aren't lining up. This may take even greater effort to figure out what happened and back out mistakes than it would have taken to just do it right to begin with.

If you go with the "Sales Tax" approach, that may be fine for your situation. But, this needs to be well documented and applied consistently. Most importantly, don't be lazy.