Yesterday, I got ahead of myself and, apparently, several others, when I was addressing the tax ramifications of a 10% cap on the FMV option at the end of the lease. Allow me to lay some background that will put yesterday’s post in better context.
In the tax world, leases are classified as either tax leases or nontax leases. The classification of a lease has important tax consequences for both lessors and lessees. In a tax lease, the lessor bears the risks of ownership and is entitled to the tax benefits associated with the equipment. Tax benefits such as accelerated depreciation represent cash inflows to the lessor. For this reason, they influence a leasing company’s pricing structure and the way it does business. Tax consequences also affect the lessee's decision-making process. In a nontax lease, which is actually a conditional sale contract in the form of a lease, the lessee is the owner of the equipment and is entitled to MACRS depreciation.
Entitlement to the depreciation is not an issue when the user of the asset also is the owner. In leasing, however, the owner (lessor) is not the user (lessee). This bifurcation of use and ownership has caused the IRS to scrutinize utilization of the tax benefits in lease transactions. The IRS takes the position that the party bearing the risks of ownership is entitled to the benefits of ownership such as MACRS depreciation. As I mentioned earlier, this determination is based on the economic substance of the transaction, not its form. (This is true in the US and most Anglo-based countries. The form of the lease does govern in many countries of the world, however.)
The criteria the IRS uses to classify leases for tax purposes come from Revenue Ruling 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. In general terms, Revenue Ruling 55-540 was issued in 1954 to address single investor leases. It took a negative approach to lease classification by stating that, if any of its criteria exist, the transaction is more likely to be classified as a nontax lease than as a tax lease.
Can you please explain if Rev Proc 2001-28 disallows down payments or trade-ins made by the lessee if all other criteria are met? I know that the revenue procedure specifically mentions permitted investments, but if the down payment/trade-in is not increasing the lessee's chance of ownership (no equity in the equipment), would this just be considered an upfront rent? Also, does it make a difference if the lease is a single investor lease or a TRAC lease?
Posted by: Tracy Miller | November 1, 2006 7:49 AM | Permalink to Comment