FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS

FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS

Remember that the Internal Revenue Service is concerned with the clas- sification of a lease because tax benefits are affected. The Internal Reve- nue Code (IRC) has requirements for a lease to be treated as a true lease. These rules are independent of the rules for classifying a lease as set forth in FAS 13. The IRC distinguishes between non-tax-oriented leases (i.e., conditional sale leases) and tax-oriented true leases. The major characteristic differentiating non-tax-oriented and tax-oriented

Equipment Leasing

true leases is the type of purchase options available to the lessee. True leases have fair-market-value types of purchase options. Conditional sale leases have nominal fixed-price purchase options or automatically pass the title to the lessee at the end of the lease.

Revenue Ruling 55-540 (1955-2 Cum. Bull. 39) states:

Whether an agreement, which in form is a lease, is in sub- stance a conditional sales contract depends upon the intent of the parties as evidenced by the provisions of the agree- ment, read in light of the facts and circumstances existing at the time the agreement was executed. In ascertaining such intent no single test, nor special combination of tests, is absolutely determinative. No general rule, applicable in all cases, can be laid down. Each case must be decided in the light of its particular facts.

A purchase option based on fair market value rather than a nominal pur- chase option is a strong indication of intent to create a lease rather than a conditional sale or lease. The test is whether the interest of the lessor in the leased property is a proprietary interest with attributes of ownership rather than a mere creditor’s security interest in the leased property.

A lease generally qualifies as a true lease for tax purposes if all of the following criteria are met:

1. At the start of the lease, the fair market value of the leased property projected for the end of the lease term equals or exceeds 20% of the original cost of the leased property (excluding front-end fees and any cost to the lessor for removal).

2. At the start of the lease, the leased property is projected to retain at the end of the initial term a useful life that (a) exceeds 20% of the original estimated useful life of the equipment and (b) is at least one year.

3. The lessee does not have a right to purchase or release the leased prop- erty at a price that is less than its then fair market value.

4. The lessor does not have a right to cause the lessee to purchase the leased property at a fixed price.

5. At all times during the lease term, the lessor has a minimum uncondi- tional “at-risk” investment equal to at least 20% of the cost of the leased property.

6. The lessor can show that the transaction was entered into for profit, apart from tax benefits resulting from the transaction.

7. The lessee does not furnish any part of the purchase price of the leased property and has not loaned or guaranteed any indebtedness created in connection with the acquisition of the leased property by the lessor.

SELECTED TOPICS IN FINANCIAL MANAGEMENT

Additional criteria and guidelines for true leases are described in various IRS Revenue Rulings and Revenue Procedures.

In structuring a tax-oriented lease transaction, corporations requir- ing the use of equipment will seek to have the lease treated as a capital lease for financial reporting purposes to avoid showing a debt obliga- tion on the balance sheet but as a true lease for tax purposes so that the tax benefits of ownership can be transferred to the lender.

While the requirements and guidelines set forth for a lease transac- tion to be treated as a true lease for tax purposes, there are transactions that the IRS might view as a conditional sales lease. If this were to occur for a tax-oriented transaction, the economics of such a transaction would be changed by an adverse IRS ruling. Consequently, for complex transactions in which the parties fear they might be viewed by the IRS as not meeting the requirements and guidelines, the parties would seek an advanced ruling from the IRS as to how it would treat the transaction.

Lease agreements generally provide for an indemnity against the possible loss by the lessor of the income tax benefits the lessor expects to receive.