The Ins and Outs on Leases

As a result of the economic downturn, are you turning to leasing as a way to preserve cash and shore up your balance sheet?

If so, have you considered whether leasing transactions are a true lease or a financing transaction for tax purposes? Are you relying on the analysis performed for book purposes to determine the tax consequences? Does the lease incorporate tax indemnification provisions?

Many companies structure leases to achieve favorable tax treatment, favorable book treatment, or both. And the trend is for the agreements to include tax indemnity provisions to protect one party from adverse tax consequences and to require the parties to report the lease for tax purposes in a consistent manner. The increasing complexity of leases, the difference in the book and tax accounting treatment of leases, and the failure to analyze the lease terms in light of the tax rules may lead to tax exposure that could in turn have a negative impact on the company’s tax provision or lead to exposure under the tax indemnification provisions of the lease.

Characterizing a Transaction As a Lease

Whether a transaction is a true lease or a financing transaction for tax purposes is determined based on the facts and circumstances, including:

  • The contractual provisions of the lease agreement;
  • The lease term compared to the useful life of the asset;
  • The amount of any purchase option compared to expected fair market value;
  • Whether the lessee is under an economic compulsion to purchase the property at the conclusion of the lease; and,
  • Other considerations set forth in IRS published guidance and case law.

This article will not discuss these factors in detail, but rather will illustrate why a separate analysis of the tax consequences of a leasing transaction is advisable with a common example. To illustrate, assume a cash-strapped company has large net operating losses and long-lived equipment with substantial built-in gain. In order to obtain cash, the company enters into a sale leaseback transaction by selling the equipment at its fair market value, recognizing gain from the transaction, and then leasing back the equipment. The lease includes the following terms:

  • A purchase option equal to 20% of the original sales price of the equipment;
  • Rent payments over the duration of the lease substantially equal to the cost of the equipment;
  • An option for the company to extend the lease beyond the stated term by continuing to pay the same monthly rent that applied during the lease term;
  • An express statement that the tax benefits of depreciating the property belong to the lessor and that the lessee will take no action inconsistent with that treatment; and
  • Lessee indemnification of the lessor’s tax benefits.

The legal department does not consult the tax department or outside tax advisors before the lease is signed, i.e., the federal tax treatment of the lease is not considered. Assume further that the lessee is likely to exercise the purchase option because the equipment has a useful life which extends substantially beyond the stated lease term and the equipment is critical to the lessee’s business.

Because gain is recognized and the lessee is tax indifferent, this transaction lacks the usual tension that exists between contracting parties. The lack of a fair market value purchase price at the conclusion of the lease creates a possibility that the transaction is a financing transaction rather than a sale-leaseback. If factually, the company determines that the transaction is more likely a financing transaction for tax purposes, the tax indemnification clause nevertheless forces the company to report the transaction as a true lease. If the company were to do otherwise, it would be faced with a potential penalty under the indemnification clause of the lease agreement. Further, the company has exposure that the lessor’s proposed tax treatment will not be sustained and it will still be obligated under the indemnification provision.

If a draft agreement had been reviewed for possible Federal tax implications, the company may have been able to renegotiate or clarify ambiguous terms to ensure that it would secure the desired tax treatment. Without clarity, the company must evaluate whether financial reporting reserves must be established for the tax indemnification under the lease.

As this example illustrates, a transaction intended to shore up the balance sheet may create exposure if the tax treatment is not considered before the agreement is signed. Timely cross-checking with tax counsel will permit resolution of most tax issues that arise in leasing transactions.

Timing of Rent Deductions for Tax Purposes

The complexity of leases relates not only to how the contracting parties characterize the transaction, but also to the treatment of rent deductions for book and tax purposes. The company’s overall method of accounting for rent needs to be considered, since the book and tax rules are different for rent deductions and a temporary book/tax difference typically results.

The general rules for deducting rent for federal tax purposes are:

  • Rent is deductible for tax purposes when it accrues under the lease agreement;
  • Economic performance occurs as the property is used; and
  • Rent payments are deemed to occur as the property is used.

These general rules are not the only tax laws to analyze. The lessee must also consider the impact of Sec. 467 leasing rules and Sec. 263(a) capitalization rules. The interaction of these rules may result in the deferral of expected tax deductions.

By contrast, the book treatment of rent expense is usually fairly straight-forward. Book rent expense is usually spread evenly over the lease term using an average rent per month (total rent due divided by number of months in the lease term). The result is deferred rent or prepaid rent, both of which would create book/tax differences.

Alternatively, a lease could be classified as a true lease for tax and a capital lease for books. When this occurs, a company depreciates the capital lease asset recorded and reports no rent expense for book purposes.

As you can see, a variety of tax rules impact the deduction for rent. Book accounting is usually not a good proxy for determining the tax deduction for rent since the book and tax treatment of rent are usually different. Companies can avoid surprises through careful analysis of the book and tax accounting before the lease agreements are signed.

Have you reviewed your company’s leases to confirm the proper characterization of the lease and the tax treatment of rent deductions? If you find a transaction that has been mischaracterized or a tax accounting method that is not proper, a tax accounting method change ruling offers a means to correct the treatment with possible back-year audit protection. Contact your WTAS advisor for assistance determining the proper tax accounting method and moving forward with corrective action, if needed.