The ultimate characterization of a lease as either a tax lease or nontax lease is not based on the tax code, per se. Instead, criteria promulgated by the IRS are used to classify leases for tax purposes. The criteria the IRS uses come from Revenue Ruling 55-540 (55-540) and Revenue Procedure 2001-28 (formerly Revenue Procedure 75-21). These criteria point to various attributes of equipment and, hence, ownership risk. The party with ownership risk under the IRS rules is entitled to deduct the tax depreciation.
The IRS issued 55-540 in 1955 in response to the increasing popularity of leasing as a financing technique. In 55-540, which addressed single investor leases, the IRS provided the following list of conditions that it has determined are indicative of lessee ownership of the equipment. If any of these conditions exist, the transaction is more likely to be classified as a nontax lease than as a tax lease (the lessee is the tax owner of the leased equipment in a nontax lease).
1. Portions of the periodic payments (rentals) are made specifically applicable to principal
2. The lessee acquires title upon payment of a stated number of rentals. This situation occurs in two ways:
a. Payment of a stated number of rentals after which title transfers
b. Title transfers automatically at the end of the lease
3. The total amount the lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the equipment cost
4. A bargain purchase option exists in which the option cost is significantly less than the expected fair market value of the leased asset
5. Some portion of the periodic payments is specifically designated as interest.
You can see that all these conditions indicate that the risk of ownership lies with the lessee.
The IRS issued Revenue Procedure 75-21 (75-21) in 1975 to provide guidance for structuring large leveraged leases. Equity investors/lessors, that were relying heavily on tax benefits, wanted to be sure their deals were considered tax leases. By meeting all the requirements of 75-21, they could obtain that assurance from the IRS. Revenue Procedure 2001-28 replaced 75-21 by incorporating and amplifying its provisions.
The guidelines of 01-28 indicate when the lessor has the risks of ownership, unlike those of 55-540, which identify factors that indicate the lessee has ownership risk. The key guidelines of 01-28 are as follows:
1. The lessor must maintain a minimum (20%) at-risk investment in the equipment throughout the lease term
2. The equipment must have a remaining life beyond the lease term of the longer of one year or 20% of the originally estimated life
3. Just like in 55-540 and FASB 13, no bargain purchase options are allowed
4. The lessee cannot make any investment in the equipment, nor make any loans, or provide guarantees, to the lessor
6. The lease must generate an economic profit without considering the tax benefits
7. The lease must generate positive cash flow without considering the tax benefits.
Lessors today continue to use 55-540 and 01-28 for determining the tax classification of their leases, along with guidance from tax court decisions. Leasing industry practices also play a role in this determination.
» A Fair Tax plan Overview Part 1 from The Staunton News Leader
The FairTax plan is a plan to replace federal income and payroll taxes. This includes personal, gift, estate, capital gains, alternative minimum, Social Security/Medicare, self-employment, and corporate taxes. [Read More]
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