Equipment Leasing and the Passive Activity Loss Rules

by David Burton

David Burton is a partner at Norton Rose Fulbright US LLP. Burton advises clients on a wide range of U.S. tax matters, with an emphasis on project finance and energy transactions. He has extensive experience structuring tax-efficient transactions for wind and other renewables, with particular expertise with respect to flip partnerships and sale-leasebacks. Burton also advises clients on the tax aspects of the formation and structuring of private equity funds, with particular expertise regarding renewable energy investment funds. Follow David on Twitter @DavidKBurton.

Due to equipment leasing’s status as a per se passive enterprise in U.S. tax law, individuals who want to invest in leased equipment must carefully consider the most tax-efficient structure for their leasing operations.

In the early 1980s, there were few hurdles to making investments for which much of the return came in the form of accelerated tax depreciation, investment tax credits and/or interest deductions. The results of this era were ugly at times. Many individuals felt they were taken advantage of by tax-advantaged investment promoters who delivered less than was promised. In addition, the IRS was displeased with the way some individuals were reducing their tax bills by making investments that required little equity or effort.

As part of the Tax Reform Act of 1986, Congress enacted the passive activity loss rules, which are in section 469 of the U.S. Tax Code and intended to serve two purposes: (i) to raise revenue to “pay for” the individual income tax rate being reduced in 1986 from 50% to 28% and (ii) reduce the opportunities for individuals to be victimized by fraudulent promoters.

On a high level, the passive activity loss rules separate income, deductions and credits into three buckets: (i) active, (ii) investment and (iii) passive. Taxable income in one bucket cannot be applied against tax deductions or credits in another bucket.

There are seven different ways for an investment to qualify as active. The typical and the most surefire way is to spend 500 hours a year working in a business that you own as a sole proprietor, partner or S-corp shareholder.

The equipment leasing industry has gone in and out of favor with Congress over the year. At times, it is viewed as an industry that encourages efficient capital formation that is stimulative to the economy. At other times, Congress has viewed it as a mechanism for tax shelters. In 1986, Congress was unhappy with equipment leasing and passed multiple measures to rein it in. One of those measures placed equipment leasing loss rules is in the passive bucket for purposes of the passive activity, regardless of how many hours a year an individual works in their leasing business. This means equipment leasing is per se passive. (There are more accommodating rules for leasing real estate. )

However, there is an exception to the per se passive treatment if the leasing income is “insubstantial” to the other income from the same business that is otherwise active. For instance, let’s say you own a factory that makes tractors through an S-corporation and you work 1,800 hours a year in the factory’s business. Let’s say you sell 97% of the tractors while leasing 3% to customers with the leases structured as true leases (also known as tax leases). In this scenario, you would be entitled to the accelerated tax depreciation. The tax attributes from the tractors would be considered “active” and the tax losses from the tractors could offset the income from selling the tractors or even your spouse’s wage income (assuming you filed a joint tax return and have a spouse). However, it could not offset income from your stock portfolio (i.e., income in the investment bucket).

Let’s look at example of how the per se passive rule becomes an issue for an equipment leasing company:
Louis works in a bank’s leasing division and is married to Sally who is a successful surgeon and earns a significant income. Louis is frustrated with the bank’s deal underwriting policies and wants to start his own leasing company. He and Sally have savings they can use as seed capital for the leasing company, and Sally’s income is sufficient to absorb all of the depreciation from the first year’s worth of lease originations.

The leasing company is a limited liability company wholly-owned by Louis and is treated as a disregarded entity for tax purposes. In the first tax year, Louis spends more than 500 hours originating, underwriting and managing transactions for his leasing company.

The leasing company generates significant depreciation tax deductions in the first year. The leasing company also originates and holds loans and buck-out leases that are taxed as loans. The loans and buck-out leases are profitable in the first year. Sally’s practice is booming and her income is twice the amount of the depreciation deductions. Also, their investment portfolio, held in a taxable brokerage account, has a good year and generates significant capital gains, dividends and interest income.

Question No. 1: If Louis and Sally file a joint tax return, can the depreciation from the leasing portfolio offset the income from Sally’s medical practice?

Answer No. 1: No. Leasing is per se passive: the depreciation deductions are in the passive bucket, despite Louis owning and working full time in the leasing business. Therefore, the depreciation deductions cannot offset Sally’s active income from her medical practice. (The answer is the same for any tax credits generated by the leased assets (e.g., a lease of a solar project). )

Question No. 2: Can the depreciation from the leasing portfolio offset the income from their investment portfolio?

Answer No 2: No. The income from the investment portfolio is in the in the investment bucket, and the depreciation deductions are in the passive bucket.

Question No. 3: Can the depreciation from leasing offset the interest income from the loans and buck-out leases?

Answer No. 3: Only if the true leases are an insubstantial portion of the leasing company’s business, which is unlikely to be the case in this example.

Question 4: What if Louis makes an election to treat the leasing company as a C-corporation?

Answer No. 4: A C-corporation, if it is closely held, meaning five or fewer individuals directly or indirectly own more than 50% of stock, is subject to the passive activity loss rules; however, the rules are far less stringent. Meanwhile, a C-corporation that is not closely held is not subject to the passive activity loss rules at all. However, even though Louis’s C-corporation is closely held, the fact it is a C-corporation would allow him to offset the interest income from the loans against the depreciation from the leases. (Such an offset would not be available if the interest income was generated by excess working capital, rather than by loans made in the ordinary course.) Since the C-corporation is a separate taxpayer from Louis and Sally, the depreciation deductions are not available to offset the income from Sally’s medical practice or the income from their investment portfolio.

Bottom line: Individuals who want to invest in leased equipment must carefully consider the most tax-efficient structure for their leasing operations.

i Temp. Reg. § 1.469-5T(a)(1). For more about the ways to qualify as active, see
iiI.R.C. § 469(c)(2).
iiiI.R.C. § 469(c)(4).
ivSee I.R.C. § 469(c)(7).
vTreas. Reg. § 1.469-4(d)(1)(i)(A) (“The rental activity is insubstantial in relation to the trade or business activity.)
viSee I.R.C. §§ 469(a)(1), (d)(2).
viiI.R.C. § 469(j)(2) (referencing § 465(a)(1)(B) (referencing § 542(a)(2)).
viiiI.R.C. § 469(e)(2).
ixSee St. Charles Investment Co. v. Commissioner, 110 TC 46 (1998) (“a closely held c corporation, unlike the other taxpayers to whom section 469 applies, … may use its passive activity loss for a taxable year to offset net active income for such year, and the amount so used will not be disallowed under section 469(a). I.R.C. § 469 (e)(2). The term ‘passive activity’ includes any rental activity, with exceptions not relevant herein. I.R.C. § 469 (c)(2).”).
x I.R.C. § 469(1)(B).

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