Structuring Leases For Tax Dollars

Maximize tax benefits when structuring your leases.

by William G. Andreozzi

Whether a material handling distributor should invest in a particular property for leasing, and how the benefits from that transaction can be maximized, are complex questions in which tax considerations are prominent. The tax classification of a particular lease is therefore very important, because the tax treatment may greatly affect the expected yields associated with the transaction

In general, a lease is viewed as a contract between a lessor (owner of an asset) and a lessee (user of an asset) by which the lessor grants temporary possession and use of the asset to the lessee, at a fixed periodic charge (rental) usually for a specified period that is less than the asset's economic life. However, even though a contract labeled as a lease may contain these characteristics, it will not necessarily be considered a lease from a tax perspective.

Lease Types
Financial accounting standards classify leases into two basic types: capital leases and operating leases. These two classifications also generally apply in the tax context. However, an operating lease is often referred to as a "true" lease, while a capital lease is viewed as something other than a lease (i.e., a disguised sale or financing arrangement). The financial accounting criteria for determining whether a lease is operating or capital is not the same for tax purposes. In fact, the traditional determination of what constitutes an operating lease for tax purposes is governed by somewhat ambiguous guidelines established by various IRS rulings and court cases.

2. Purchase and sale rights: No bargain purchase options are allowed. The lessee must pay fair market value for the leased asset. Fair market value must be at least 20 percent of the asset's cost.3. No investment by lessee: No part of the cost of the property may be furnished by the lessee. Improvements or additions to the property must be paid by the lessor unless they are owned by the lessee, are easily removable without causing damage, and are not subject to bargain purchase options exercisable by the lessor.4. No lessee loans or guarantees: The lessee may not lend to the lessor any of the funds necessary to acquire the property or guarantee the indebtedness.5. Profit requirement: The lessor must make a profit beyond the tax benefits derived from the depreciation tax shield. This test is met when the total rent paid by the lessee together with the estimated residual value are greater than disbursements for nonrecourse debt services and equity investments including interest for the recourse debt portion.6. Uneven Rents: Lease payments may not fall under the IRS definition of uneven rents.

7. Property cannot be special purpose property: Special purpose property without an alternate use cannot be the subject of a "true" lease.

For every tax advantage, however, there is usually a disadvantage. As a lessor's accelerated depreciation deduction becomes larger, the possibility that the lessor will be subject to the alternative minimum tax (AMT) becomes greater. Alternative minimum tax is an additional tax that may apply to taxpayers who take advantage of certain tax benefits, such as accelerated depreciation. The AMT has the effect of minimizing the tax benefit associated with accelerated depreciation because, for AMT purposes, accelerated depreciation is not allowed as a deduction. Lessors with large quantities of "true" leases may not receive the full benefit of accelerated depreciation deductions if they are currently paying AMT. Therefore, some of the lessor's accelerated depreciation deductions are wasted. If, however, a lessor has unused net operating losses (NOLs), a capital lease may provide larger tax savings.From the lessor's perspective, a capital lease is treated as if a sale of that asset to the lessee has occurred. The lessee is treated as having all incidents of ownership from a tax perspective. Therefore, the lessor only reports the income from the lease, while the lessee is entitled to accelerated depreciation deductions. If the lessor has unused NOLs, this rental income may be offset by those NOLs, resulting in tax savings that may not have been present by using an operating lease.Because of the different tax treatment of operating and capital leases, a lessor may be able to maximize its tax benefits by properly structuring its lease arrangements. Generally, when a lessor is not in an AMT situation, operating leases may provide the largest tax benefit through accelerated tax depreciation, while lessors who are currently paying AMT, with unused NOLs, may obtain more tax benefit by entering into capital leases and thus utilizing its NOLs. To the extent the lessor has the ability to set the terms of the lease, it would be wise to review the lease provisions in conjunction with the IRS criteria in order to structure the lease in the most tax effective manner.

In material handling, the opportunity to maximize tax savings may be present under either classification or a combination of the two. Therefore, it is important to analyze the potential tax impact of any new leases to determine which tax classification will yield the greatest tax benefit to the lessor. A tax professional will be able to customize an analysis to your particular tax situation and will be familiar with any other tax limitations that should be considered in making a determination.

¹ 1975-1 C.B. 715

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The MHEDA Journal • Fourth Quarter 1999 • Volume 28, No. 4 • Contents are Copyright © Data Key Communications, Inc.
All rights reserved. • Nothing may be reproduced in whole or part without written permission of the publisher.