One important economic factor to consider with any equipment lease is how the transaction will be reported for income tax purposes.
This determination is made based on the terms of the lease agreement, and has a large impact on the overall tax effect. Further, due to different criteria used for lease classification by the IRS and The Financial Accounting Standards Board (FASB), a lessor could have the same lease treated differently for book and tax purposes.
Consider the variables this brings into play.
From the lessor’s perspective, if the lease contains a bargain purchase option or automatically transfers ownership of the asset to the lessee at the end of term, the lease should be classified as a non-tax lease, or conditional sale, for tax purposes. This means that the equipment is not capitalized on the lessor’s tax return, and that income is recognized over the term of the lease using the interest method. However, if the lease contains an FMV purchase option or a purchase option stated as a percentage of the original equipment cost (usually 10% or greater) the lease is generally considered a tax lease, also known as an operating lease, for tax purposes. In this case, the equipment is capitalized on the lessor’s tax return, and rental income is offset by the associated depreciation expense.
The treatment/presentation of leases for financial statement reporting is determined by applying four quantitative tests outlined by the FASB. The tests are:
If any one of these tests is met, the lease will be treated as a direct finance lease for financial statement reporting by the lessor. Both the lessor and lessee must review these tests at the outset of the lease and determine independently how it should be classified.
In fact, it is possible for a single lease to be considered a direct finance lease by the lessor and an operating lease by the lessee for financial statement reporting purposes, based on various subjective criteria that may be interpreted differently by the lessor and lessee. Because the criteria for classification are not the same for book and tax purposes, this can lead to situations where the lessor classifies a lease as a direct finance lease for book purposes, and an operating lease for tax purposes.
For example, let’s say you enter into a lease for $10,000 worth of equipment, with 60 payments of $184.89, a 20% residual and a July 1 start date. The equipment has a five-year modified accelerated cost recovery system (MACRS) life for income tax purposes (no bonus or Section 179 depreciation is employed in this example). The lease is classified as a direct finance lease for book purposes and an operating lease for tax purposes.
Book income (rental income
(finance income) less depreciation) Difference
Year 1 $ 400 $ (891) $ 1,291
Year 2 868 (981) 1,849
Year 3 727 299 428
Year 4 571 1,067 (496)
Year 5 398 1,067 (669)
Year 6 129 2,532 (2,403)
Total $ 3,093 $ 3,093 $ 0
Treating a lease as an operating lease for tax purposes defers the recognition of any cumulative taxable income on the lease until year five.
Changes to Bonus Depreciation and Section 179
In late 2015, Congress passed legislation extending the income tax provision related to bonus depreciation through 2019, allowing for the immediate expensing of a portion of the equipment cost for new equipment placed in service through 2019. Many leasing companies were relieved by this extension, as they had come to rely on the significant bonus depreciation generated from tax leases entered into in the current year to offset their taxable income.
As a reminder, the bonus election must be made by class of assets, so you cannot pick and choose individual pieces of equipment on which to apply bonus deprecation. It is a blanket election by asset class. Electing this provision accelerates depreciation taken in the initial year, but drastically reduces future years’ depreciation deductions.
Currently, bonus depreciation is set to continue at 50% of equipment cost for 2016 and 2017. The percentage drops to 40% for 2018 and then to 30% for 2019. There are no provisions for bonus depreciation to continue after 2019, though time will tell.
In addition to extending bonus depreciation, Congress permanently extended the increased Section 179 deduction limits. Under the new rules, companies can immediately expense up to $500,000 of equipment cost per year, and the deduction can be applied to new or used equipment. For businesses that place more than $2 million of equipment in service during the tax year, the Section 179 deduction will be phased out dollar-for-dollar and will be completely eliminated at $2.5 million of equipment placed in service.
For equipment depreciated using the regular MACRS method of depreciation, you are also required to compute depreciation for AMT (alternative minimum tax) purposes. MACRS uses the 200% declining balance method for regular tax, but AMT requires the use of the 150% declining balance method over the same recovery period. Depending on your individual tax situation, this AMT adjustment could have a large impact on your tax liability.
A less publicized advantage of electing bonus depreciation is that equipment on which bonus depreciation is taken is not subject to the AMT depreciation adjustment, which could provide additional tax savings for leasing companies.
What to Expect Going Forward
As previously mentioned, starting in 2020 there will be no new bonus depreciation to offset the rental income from leases originated in prior years, which could generate large taxable incomes and larger than normal tax liabilities.
Assume you originated one lease in each year from 2016 through 2019, using the information in the example above. The rental income recognized from the four leases would be $8,875 ($184.89 x 12 x 4) in 2020, but the depreciation expense related to the four leases would only be $4,544.
The same lease originated in 2020 using MACRS depreciation will produce a tax loss of $891 netting to taxable income of $3,653 for the five leases combined.
Extrapolating this information to your entire operating lease portfolio, you can see the potential impact the elimination of bonus depreciation will have in 2020. Depending on your individual tax situation, it may make sense to reduce the amount of bonus depreciation elected for the next few years. Managing your tax liabilities by taking less bonus depreciation in 2016 and forward could flatten out your taxable income, reducing the tax shock in 2020.
There is also talk of raising tax rates in the future, so paying some tax earlier at lower rates could be beneficial from this perspective as well.
State and Local Taxes
Owning leased equipment in states other than your home state can create income tax filing requirements for those states and sometimes at the city level. State filing requirements can increase the complexity of your tax return substantially because every state’s tax return is different.
If you are an owner of a pass-through entity such as an LLC or an S corporation, you may have personal state filing requirements as well. However, most, but not all, states allow the owners to be included in a composite return filed at the entity level. If you elect to be included in the composite returns filed by the company, you are not required to file personally in those states. You can elect to be included in a composite return for a particular state only if you have no other income in that state besides the income from the pass-through entity filing the composite return.
Composite returns generally calculate the tax at the highest marginal individual rate with no deductions. With that in mind, depending on the amount of income allocated to each state, it may make sense to elect out of the composite filing for states with high individual tax rates such as California, Minnesota and New York in order to maximize any potential tax savings. State tax liabilities will create the need to file quarterly estimated payments either at the company level through composite filings, or at the individual level.
The impact of bonus depreciation on taxable income at the state and city level should also be reviewed. Approximately two-thirds of states do not allow bonus depreciation or use some reduced expensing formula. So, you could have a loss for federal income tax purposes but income for state tax purposes, whether filing composite at the entity level or on an individual basis.
A Word On Tax Audits
With the improvement of technology at the federal and state levels, the various government agencies are starting to communicate with each other regarding tax issues.
This is beginning to have an impact on audits.
If you are audited by the federal government and the audit produces an additional tax liability, you can be pretty sure that you will receive correspondence from the states where you do business looking for additional tax as well. The various agencies within the state departments of revenue are also talking with each other. So, if you are filing sales tax returns in a particular state but not filing income tax returns, you will probably get a request for information to explain why you are not filing an income tax return. If it is determined that you should have been filing state income tax returns you may be responsible for filing returns as far back as your activity began in that state.
Please note, filing a tax return starts the three-year statute of limitations for audit purposes, but if you never filed a return in the jurisdiction, the three-year statute of limitations never starts.
Accounting and tax rules for leasing companies are complex and require the accumulation of substantial amounts of data to prepare accurate financial statements and tax returns.
To add to the existing complexities, FASB released new leasing standards earlier this year that will be important for the lessor to understand from both the lessor and lessee perspectives.
Leasing software is a critical tool for collecting financial and tax information, and making the entire process more efficient, but a good understanding of GAAP and federal and state tax rules, combined with proper planning and analysis, will go a long way to help manage your tax burden and keep your business financially secure.