In my post yesterday, I outlined the criteria the IRS uses to determine true tax lease status. I also noted that the ultimate characterization of a lease is not based on the tax code. This power lies with the tax courts, which consider all the economic characteristics of the transaction and how they relate to the criteria established by the IRS. The courts have focused historically on three key variables in reaching their decisions. These variables are risk, the intent of the parties, and the economic merits of the transaction.
The courts follow the IRS philosophy that the party bearing the risks of ownership should receive the tax benefits of ownership, so much of their analysis is spent in determining risks of ownership. The courts often refer to 55-540 and 01-28 to help identify and allocate risk. Their prime focus, however, is the issue of residual risk, as residual risk is the clearest indicator of ownership risk. For instance, a tax lease should not contain a bargain purchase option such as a dollar out. Nor should it require the lessee to guarantee the residual value, or compel the lessee to purchase the asset at any time during the lease term. The lessor does not have any residual risk in any of these situations.
The courts try to establish and judge the intent of the parties. Does the lessee intend to seek ownership, even though the transaction is structured as a lease? To establish the intent of the parties, the courts may examine past as well as current transactions, and scrutinize purchase options. The courts also review the transaction to determine if it has any economic merit. For example, does the lessor have any economic reason to lease the asset, other than for tax benefits? Positive cash flow and the level of economic, pretax profit are the two most common factors considered.
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