If two commonly-owned S corporations merge into one, does that eliminate the sales tax that used to apply when they sold lumber products to each other, and does merging change the manufacturing exemption on the equipment involved?

Plain-English summary

Two S corporations with common shareholders, S1 and S2, were considering a merger to eliminate duplicate overhead. S1 buys raw lumber, primarily to manufacture pallets, but also cuts some of that lumber into pickets and cuts-and-nails other lumber into fence panels, which it sells to S2. S2 builds and installs fences for homebuilders. S1 paid no sales tax on the equipment it uses to cut and nail the lumber (claiming the manufacturing exemption), while S2 pays sales tax on the pickets and panels it buys from S1. Because S2's competitors do their own cutting and nailing in-house, those competitors pay sales tax only on raw lumber cost, not on the "mark-up" S2 pays for S1's cutting/nailing value-add — putting S2 at a pricing disadvantage. The companies asked whether merging (making S1 and S2 divisions of one corporation instead of separate entities) would eliminate the sales tax currently charged on the lumber sold from S1 to S2.

The Comptroller's answer was two-sided. On the good news: after a merger, if S1 and S2 become divisions of the same single corporation, sales tax would NOT be due on transfers or sales between the divisions — this fixes the exact pricing problem the companies were trying to solve. On the bad news: merging does not fix a separate, underlying issue. Because S2 (now a division) is a contractor that installs the fences, the S1 division still could not claim the manufacturing exemption on its cutting/nailing equipment — the manufacturing exemption requires the output to be sold onward as tangible personal property, and S2's installation-contractor role doesn't fit that mold merely by becoming an internal division. The letter closes with the general divergent-use rule: when equipment is used partly in manufacturing and partly in a nonmanufacturing operation, the owner owes tax based on the fair market rental value of the equipment for the nonmanufacturing-use period, or on the original purchase price, under Rule 3.287(e).

What this means for you

Commonly-owned companies considering a merger to eliminate intercompany sales tax

Merging separate entities into divisions of a single corporation does eliminate sales tax on transfers between them — a real, achievable fix for exactly the kind of markup-tax problem described here.

Manufacturers whose output ultimately goes to a contractor for installation

Don't assume a corporate restructuring alone resolves manufacturing-exemption eligibility. If your cutting/fabrication equipment feeds into a division (or company) that installs the finished product as a contractor rather than reselling it as tangible personal property, the manufacturing exemption on that equipment remains at risk regardless of how the entities are organized.

Accountants and tax professionals

This letter usefully separates two distinct issues that a merger analysis often conflates: intercompany transfer taxability (fixed by merging into divisions) versus manufacturing-exemption eligibility for equipment (an independent test tied to what happens to the output, unaffected by the merger).

Common questions

Q: Does merging two companies into divisions eliminate sales tax on sales between them?
A: Yes — sales tax is not due on transfers or sales between divisions of the same single corporation.

Q: Does the merger fix the manufacturing exemption on the cutting/nailing equipment?
A: No — if the division receiving the cut/nailed lumber is a contractor installing it (not reselling it as tangible personal property), the producing division still cannot claim the manufacturing exemption on that equipment.

Q: What happens if equipment is used for both manufacturing and nonmanufacturing purposes?
A: The owner owes tax based on the fair market rental value of the equipment for the nonmanufacturing-use period, or on the original purchase price, under Rule 3.287(e).

Q: Can other similarly-situated companies rely on this exact letter?
A: No. This is a Texas STAR letter ruling binding on the Comptroller only for the taxpayer it addresses (34 Tex. Admin. Code Rules 3.1, 3.10); confirm your own facts with a tax professional.

Citations and references

Rules:

• 34 Tex. Admin. Code § 3.287(e) (divergent use of items purchased under an exemption certificate)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/200009668L

Original ruling text

September 5, 2000

From: Bettie Peterson

To: "Montes, Joel"

Subject: Sales tax

Thank you for your recent email.

Your question: Would the merger and the elimination of inter-company sales
eliminate the sales tax currently payable on the sale of lumber from S1 to S2?

Response: After the merger, if S1 and S2 are divisions of the same corporation,
sales tax would not be due on transfers or sales between the divisions.

However, because S2 is a contractor installing the fences, S1 division would
not be able to claim the manufacturing exemption on equipment used to produce
the pickets and fence panels.

I should point out that when machinery and equipment is used in both a
manufacturing and in a nonmanufacturing operation, the manufacturer owes tax
based on the fair market rental value of the equipment for the period of time
used in a nonmanufacturing operation or on the initial purchase price. See Rule
3.287(e) concerning divergent use of items purchased under an exemption
certificate.

Referenced rules are available at
.

The State Tax Automated Research system, that provides viewing and downloading
of rules, edited letter rulings, hearings, AG Opinions, etc., may be accessed
on the Internet at .

This opinion is based on the facts you submitted and current law. Other facts,
though similar, may result in different answers.

If you have questions or need more information, I will be glad to help you.
You may call me toll free from anywhere in the United States at 1-800-531-5441,
extension 5-0330.

Date: Thu, 24 Aug 2000 10:14:39 EDT
From:
Subject: Sales tax

My client is now wanting more information regarding a possible business
reorganization. The facts are as follows:

There are currently two S Corporations, S1 and S2. S2 builds and installs
fences for home builders. S1 buys lumber primarily for the manufacturing of
pallets. Some of the raw lumber is cut into pickets and sold to S2. Some of
the raw lumber is cut, nailed to rails to form panels, and is then sold to S2.
Sales tax was not paid on the purchase of machines used to cut and nail the
lumber. S2 pays sales tax on the pickets and panels purchased from S1. The
competitors of S2 perform the cutting and nailing "in house" and therefore pay
sales tax on the cost of lumber only, and not the "mark up" attributable to the
enhanced value of cutting and nailing. Due to the additional cost of raw
materials attributable to the sales tax paid, S2 is not able to price his
product competitively.

S1 and S2 have common shareholders and are considering a merger in order to
eliminate duplicate overhead.

Issue: Would the merger and the elimination of inter-company sales eliminate
the sales tax currently payable on the sale of lumber from S1 to S2?

If you are not able to respond, could you please forward this to the
appropriate division? I'd appreciate any reference to Rule numbers etc.

Thank you,