In a new Ask the Monitor column, lease accounting expert Bill Bosco tackles two of the most common — and most misunderstood — questions around TRAC leases and residual values, clarifying what it really takes to structure a true, compliant operating lease under ASC 842 and IRS rules.

I field a lot of questions about lease accounting. This article answers a few questions that may have broad interest.

Question: Is it possible to structure a Terminal Rental Adjustment Clause (TRAC) lease that fully amortizes (also known as a Zero TRAC) such that the lease is a true lease and an off-balance sheet (now partially off-balance sheet under ASC 842) operating lease? 

Many fleet managers want a 50-month TRAC lease with a 2%-per-month “amortization,” so they can easily calculate the TRAC value of any vehicle by multiplying 2% by the number of months elapsed in the term. The typical fully amortizing fleet lease has a 12-month firm term followed by a series of 38 monthly options to renew or terminate with a TRAC adjustment. The maximum lease term is 50 months, at which point the TRAC is fully amortized.

Answer: The short answer is yes, but first, I should say check my answer with your tax and accounting advisors to make sure they agree.

In my opinion, to be an operating lease for accounting purposes, and thus off balance sheet (now partially off balance sheet under ASC 842), the structure must include the following:

1. There can be no lessee fixed price purchase option. The major accounting issue is to make sure the structure does not include an option to buy the vehicle for the TRAC amount at expiry, as an option to buy for zero is a bargain for accounting purposes. Regarding fixed price purchase options set at the TRAC amount during the term, they are problematic at any point along the term where the option price is less than the expected fair market value.

That is virtually certain to happen due to the steep amortization pattern compared to the expected fair market value curve of the leased vehicle. Also, the periods that precede a bargain purchase option are included in the lease term for accounting purposes, which will impact the structuring of the amount of residual risk the lessor must assume (the longer the lease term, the more risk the lessor must assume).

2. The structure must include a split, or modified, TRAC, that is, a TRAC with a capped residual guarantee. The residual guarantee is capped at an amount in the TRAC structure that when the guarantee is included as a minimum lease payment in the present value calculation of the remaining minimum lease payments (rents and residual guarantees) in the lease term and any renewal term, results in a present value that is less than 90% of the vehicle’s fair value at the beginning of the applicable lease or renewal term.

In my opinion, for tax purposes, the major concern is also regarding purchase options. There can be no bargain purchase option, as that would violate the IRS true lease guidelines. The term “terminal rental adjustment clause” means a provision of an agreement that permits or requires the rental price to be adjusted upward or downward by reference to the TRAC amount realized by the lessor under the agreement upon sale or other disposition of such property (note there is no mention of inclusion of a purchase option in the TRAC definition).

IRS Code §7701(h)(1) provides that in the case of a qualified motor vehicle operating agreement that contains a terminal rental adjustment clause (a TRAC lease), the agreement is treated as a lease if (but for such terminal rental adjustment clause) the agreement would be treated as a lease for federal income tax purposes and the lessee is not treated as the owner of the property subject to the agreement during the period the agreement is in effect. What this means is that, but for the TRAC provision, the lease must meet the true lease guidelines, which prohibit bargain purchase options.

In summary, the lease cannot contain a bargain purchase option for both IRS and ASC 842 treatment as a true lease and an operating lease, and the present value of the minimum lease payments must be less than 90% of the fair value of the vehicle at the beginning of the firm term and any renewal term for ASC 842 operating lease classification.

Question: In the accounting for a true lease, can one record a 0% residual even though the IRS guidelines require the leased asset have at least a 20% residual value at the end of the lease?

Answer: U.S. GAAP defines the residual value to be booked as “the estimated fair value of the leased property at the end of the lease term.” In practice, lessors book a conservative value rather than the “true” expected fair value of the leased asset at lease expiry to avoid residual write-downs or residual losses.

In essence, most lessors are interested in maintaining the quality of earnings, so they assume conservative residuals. In my experience, I have seen many leases where a low, and at times zero, residual was booked because of the nature of the asset, while there was documentation in the tax files to support that, in a best-case scenario, one could expect the asset to have a 20% value at the end of the lease term.

Some even argue that the 20% residual comes from Revenue Procedure 2000-28 that applies to leveraged leases, not non-leveraged leases, so there may not be a 20% residual value “requirement.” 

Editor’s Note: This article is the first edition of a new series, Ask the Monitor, in which Monitor’s stable of equipment finance experts answer questions from readers. Email your question to rita.garwood@www.monitordaily.com. 

Bill Bosco is the CEO of Leasing 101, a lease training and consulting company. Bosco has more than 50 years of experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, pricing and training. 

He served on the EFLA accounting committee from 1988 to 2017, including as chairman for 10 years. He is a frequent author and speaker on leasing topics and was selected to the FASB/IASB Lease Project working group. He was inducted into the ELFA Hall of Fame. He can be reached at wbleasing101@aol.com, leasing-101.net or 914.522.3233.