It’s a good idea, but don’t be too conservative re: the IRS checklist.
Accounting Lease Classification:
My experience is that the checklist criteria lessors use to determine whether a lease is classified as an operating or a finance lease are simple, standard, and straightforward. Here is an example:
The main reason it is easy is that the US GAAP classification criteria in ASC 842 are clear, and where judgment is involved, the FASB has provided guidance in the form of “bright line” values for the present value test and the useful life test. The style of the FASB rules has been called a “cookbook” approach with details – the US business world likes clarity and certainty, and the FASB generally gives that to them.
IRS Lease Classification:
My experience is that the checklist criteria that lessors typically use to determine whether a lease is a true lease or a financing are overly conservative. The IRS lease classification guidance is not straightforward and involves judgment. The primary guidance for all leases is Revenue Ruling 55-540, but many lessors use the IRS guidelines for advance rulings on leveraged leases (Revenue Procedure 2001-28) to develop their checklist. Traditional “leveraged leases” (that is, the special accounting method for three-party leases that allowed netting of non-recourse debt and revenue recognition using the MISF yield method) are no longer permitted under GAAP, but lessors often “back-lever” their true leases with non-recourse debt, thus limiting the lessor’s at-risk position. In non-leveraged true leases, the lessor is 100% at risk – a very different risk profile.
IRS Revenue Ruling 55-540 is a federal tax guideline (not a rule) used to help IRS auditors determine whether an equipment lease is a true lease (a rental) or a conditional sales contract (a purchase). It looks at the intent of the agreement based on specific facts rather than just what the contract is named.
The IRS considers an agreement a purchase instead of a lease if any of these conditions happen:
- Part of each “rent” payment goes toward owning a piece of the property.
- You get legal ownership of the item after paying a set amount of total rent.
- Short-term rent payments are very large compared to the total price needed to get title.
- You pay much more than the actual fair market rent value for the item.
- You can buy the property at the end for a nominal (bargain) price compared to its real value.
- Part of the money you pay is marked or easily recognized as interest.
IRS Revenue Procedures 2001-28 and 2001-29, issued in May 2001, are formal documents issued by the IRS that give lessors four criteria needed before the IRS would consider issuing an advance ruling as to whether a proposed leveraged lease would likely be classified as a true lease.
- The lessee does not have an option to purchase the asset for less than FMV.
- The expected residual value is at least 20%, and the lessor bears all residual risk.
- The leased asset must be general-use property and have an estimated remaining useful life at
the end of the lease equal to at least 20% of the original estimated useful life.
- The lease must satisfy the IRS requirements for profit exclusive of tax benefits, cash flow, and minimum equity investment.
The issue that Rev Proc 2001-28 focuses on is lessor minimum investment risk – the lessor must have made a minimum unconditional “at risk” investment in the property when the lease begins, must maintain such minimum investment throughout the entire lease term, and such minimum investment must remain at the end of the lease term. The percentage of lessor risk is a concern given that the non-recourse debt theoretically limits the lessor’s risk of loss. Tax lawyers have opined that since 7-10% ITC was typically a part of a leveraged lease and immediately reduced a lessor’s risk level, 10% at-risk versus 20% is enough risk to still be a true lease.
Most lessors use the following as a true lease checklist, but I think it is too conservative:
I recommend the following true lease checklist with revised amounts for the lease term and residual value questions.
Conclusion
I am not a tax lawyer, but I base my opinions on my experience with leveraged leases and discussions with lawyers. If you agree with my analysis, check with your tax experts first before implementing my ideas.
About the Author:
Bill Bosco is the CEO of Leasing 101, a lease training and consulting company. Bill has 50+ years’ experience in the leasing industry. His areas of expertise are accounting, tax, financial analysis, structuring, and training. He is a frequent author and speaker on leasing topics. He has received awards from the Equipment Leasing and Finance Association (ELFA) and Monitor magazine, including being inducted into the ELFA Hall of Fame. He can be reached at wbleasing101@aol.com. Check out his website at leasing-101.net.
