After writing my last post on the changes to some of the tax rules for tax-exempt entities, I realized that not everyone may be familiar with this segment of the leasing business. So, what is a tax-exempt lease, anyway? While most leases are written with commercial entities, the tax-exempt world also utilizes leasing to finance its equipment needs. We generally refer to tax-exempts as those entities that are not subject to income tax. These entities include the federal government, states, cities, counties, hospitals, universities, port authorities, health authorities, charitable organizations, and churches, to name a few.
Aside from the profit motive, tax-exempts are not much different than commercial companies when it comes to their leasing needs. They use leasing to conserve cash, obtain off balance sheet financing, simplify record keeping, and, in the case of municipal leases, avoid having to obtain voter approval for the financing. Tax-exempt leasing is generally differentiated from commercial leasing based on the tax rules, however. Leases to tax-exempt organizations can be characterized as either tax-exempt user leases or municipal leases.
Tax-exempt user leases are tax leases written with tax-exempt or nonprofit organizations, including the federal government, the states, and cities. The IRS ownership requirements for a tax lease, therefore, must be met by the lessor. This lease is still considered a tax lease, even though the user does not pay federal income taxes. The lessor records the full payment as rental income in its tax return. Although depreciation is deducted, it is, in most cases, at a slower rate than the standard MACRS schedule (i.e., on a straight-line basis, rather than accelerated).
Municipalities can enter into a special nontax lease called a municipal lease, which is considered debt for federal tax purposes. It is considered a lease under state laws, however, because it can be canceled at the end of each year. This type of lease specifically is not available to the federal government. Other tax-exempt entities must have certain characteristics, such as police powers and the right of eminent domain, in order to take advantage of this form of lease financing.
The interest rate must be stated in a municipal lease, and the municipality owns the equipment at lease termination. The key benefit to the lessor in a municipal lease is that its interest earnings are tax-exempt. The lessor passes this tax saving on to the municipal lessee by charging a lower payment than it would charge a taxable organization.
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