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Tax The Runway

Jennifer Hyman
Jennifer Hyman, co-founder of Rent the Runway. Photo by Noam Galai, courtesy TechCrunch.

How many times did you wear your prom dress?

For most people, that answer is probably “once.” The same can likely be said of that dress you picked up for a black-tie gala or any other truly formal occasion. And everyone who has served as a bridesmaid knows that dress that “you can definitely wear again” will end up a sunk cost, languishing in the back of your closet or relegated to the next batch of Goodwill donations.

When formal wear means a tuxedo, rental has been an option since the early 20th century. So perhaps what’s surprising is not that gown rental has become big business, but rather that it took this long to catch on.

Rent the Runway is the giant in the clothing rental industry, founded by Harvard Business School classmates Jennifer Hyman and Jennifer Fleiss back in 2009. Though it was originally a strictly online venture, the company has recently branched out into a few brick and mortar locations, and it secured a new $60 million funding round late last year. I’ve used Rent the Runway myself when attending black-tie galas; gowns appropriate for such occasions aren’t easy to wear more than once, and a rental allows you to pay a fraction of the cost of buying the same item outright.

Rent the Runway offers both pay-as-you go and subscription options. You can rent a garment for four days or eight days or, for monthly subscribers, you can keep the item until you’re ready to exchange it for something new. The company also offers bags, scarves and jewelry, allowing you to create an entire outfit for a particular occasion if you wish.

Given Rent the Runway’s success, it is no surprise competitors quickly made their mark too. Le Tote focuses on everyday wear and offers a maternity program (ideal for a customer whose size is constantly changing). Gwynnie Bee offers rental options in plus sizes and Union Station focuses on bridesmaid dresses. Even suit rental has migrated online, with companies like The Black Tux encroaching on the traditional tuxedo rental market. And new up-and-comers are appearing all the time, focusing on juniors’ sizes, accessories and more.

While some observers initially expressed skepticism that customers would want to rent their day-to-day work clothes the way they might rent a formal gown, the success of these services so far suggests “Netflix for clothes” can appeal to those too busy to shop or hungry for more variety than their clothing budget allows. In an interview with Recode, Hyman compared the fashion industry to the automotive industry of days gone by. Some people will always prefer to buy a car, but some will prefer to lease – and some may just rent a limo for a special night out.

Some of these services let you buy an item if you fall in love with it. Rent the Runway offers this option on certain “unlimited” rental items and on clearance merchandise. Le Tote, on the other hand, has purchase built in to its subscription model; in each new box, you can purchase any item you want to keep indefinitely. It sounds simple, and from a customer’s perspective, it is clearly meant to be.

As a customer, I appreciate the convenience. But as a tax professional, I couldn’t help but pause and think about how a company that both rents and sells clothing – generally the same clothing – would handle their taxes.

Offering any sort of rental can complicate depreciation, which is a major part of most companies’ tax planning. Clothing rental companies must, of course, report their gross income for the rentals, as well as any additional payments they collect for services, such as cleaning fees. Like any company, they will look to offset some of their taxable income by deducting typical business expenses – including depreciation of the business’ assets.

The idea behind depreciation of property is that, over time, property becomes obsolete, deteriorates or just sustains sufficient wear and tear that it becomes less valuable. Where clothes are concerned, it is inevitable that over time, trends will fade, colors will wash out and buttons will go missing. (This is the reason that businesses can’t depreciate land; it does not wear out or get used up over time, even if it may require upkeep.) A business begins depreciating an asset on the day it starts using it, and stops either when the cost has been fully recovered or when the property is retired from service, whichever happens first.

As with many tax issues, depreciation sounds simple in the big picture, but in actual practice it can become quite complicated. The Internal Revenue Service’s guide to depreciation (Publication 946) is over 100 pages long. In part, this is because there are several types of depreciation depending on the asset in question, the nature of the company and the depreciation method that is most advantageous for the business’ overall tax situation.

For example, the Section 179 deduction allows companies to deduct the full amount of an asset up to $500,000 in the year it is placed in service, rather than depreciating it over time. If the cost of your qualifying property placed in service in a year is more than $2,010,000 (as of 2016), you generally must reduce the dollar limit by the amount of cost over that threshold, though you do not have to reduce the limit below zero. Thus if the cost of your property placed in service during 2016 is $2,510,000 or more, you cannot take a Section 179 deduction at all.

But for a service like Rent the Runway, those rules are not quite all there is to it; there are special rules for taking the 179 deduction for leased property. Generally, you cannot claim a Section 179 deduction based on the cost of property you lease to an individual. However, there is an exception as long as two tests are met. First, the term of the lease, including renewal options, must be less than half of the property’s “class life” (the number of years the IRS says the property will be considered useful). Second, for the first 12 months after the lessee takes possession of the property, the total business deductions you are allowed must be more than 15 percent of the rental income the property generates. If both these tests or met – or if you manufacture the property that you’re leasing – you may be able to take a Section 179 deduction even on property you rent out.

Of course, there are simpler ways to handle depreciation, too. A more traditional method is the
Modified Accelerated Cost Recovery System (often abbreviated MACRS). MACRS involves assigning the asset to a specific asset class for its useful life based on class categories the IRS provides and depreciating according to that period.

What about those sales of property that used to be rented I mentioned? The company must then report the sale of the asset and any gain above the basis – that is, the business’ original investment in the property. If the companies depreciated these items and dropped the basis lower than the piece’s current fair market value, such a gain is likely. The key here is that any gain from the sale (up to the point of what you initially paid for it) is taxed as ordinary income, rather than as a capital gain, because of the IRS’ recapture rules.

For instance, say your business bought an asset for $5,000. You then took a Section 179 deduction for the full $5,000 possible in the year you started using it to generate income, so the asset’s basis is now $0. If you turn around and sell the asset for $6,000, then for tax purposes, $5,000 will be ordinary income and the remaining $1,000 will be capital gains.

Are services like Rent the Runway navigating Section 179 deductions, using MACRS or doing something else altogether? I don’t know, since they aren’t my clients. But it is interesting to consider how such a business might make the most of depreciation when dealing with property where “wear and tear” is quite literal. Creative thinking about the structure of your business can lead to commercial success, but it can also lead you into some complicated tax questions.

Client Service Manager Melinda Kibler, who is based in our Fort Lauderdale, Florida headquarters, contributed several chapters to our firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning;” Chapter 10, “Financing Long-Term Care;” and Chapter 17, “Retiring Abroad.”

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