If you want to derive tax benefits for your business for getting an equipment lease, you need to understand the difference between different structures of leases and how the IRS treats them. Bear in mind that IRS treatment of leases (True Leases or Non-Tax Leases) may be different from accounting treatment of leases (operating leases or capital leases).
Common Types of Lease Structures
Before we get into the accounting or tax treatment of leases, let us first discuss the three most common types of lease structures. For the avoidance of confusion, the lessee is the company that uses the equipment and the lessor is the company that provides financing for the equipment being used.
$1 or 100 Purchase Option Lease:
This type of lease structure has a fixed monthly payment and the lessee owns the equipment at the end of the lease term for a $1 or $100 payment, as the lease agreement may provide. This is also referred to as a lease-purchase. These leases are treated as capital leases and are generally Non-Tax Leases for tax purposes, thereby making only the interest expense component of the payment tax deductible. Depreciation is also deducted by the lessee.
10% Purchase Option Lease:
This type of lease structure has a fixed monthly payment with a fixed purchase option. The lessee’s end-of-lease options are to purchase the equipment at 10% of its original cost, renew the lease, or return the equipment to lessor, as the lease agreement may dictate. These leases are treated as capital leases and are generally Non-Tax Leases for tax purposes, thereby making only the interest expense component of the payment tax deductible. Depreciation is also deducted by the lessee.
FMV (Fair Market Value) Purchase Option Lease:
This type of lease structure has fixed monthly payments with a fair market value (FMV) purchase option. At the end of the lease, the lessee can purchase the equipment at fair market value or return the equipment to the lessor. The lessee may have the option to renew the lease or upgrade the equipment. These leases generally qualify as operating leases and can be True Leases for tax purposes. Monthly payments under this option are generally the lowest and are 100% tax deductible as rental expense.
Book Accounting vs. Tax Accounting
Now that we understand the common types of lease structures, it would help to understand the difference between book accounting and tax accounting.
Book accounting is different from tax accounting in that it complies with Generally Accepted Accounting Principles (GAAP) rather than complying with the Internal Revenue Code in tax accounting. The books or financial statements that your company keeps follow book accounting principles. GAAP rules exist to accurately depict the financial status of a company, including history, strength and business prospects. If you are looking to get a loan or sell your business, the bank or buyer will want to look at your GAAP books. On the other hand, tax accounting is used solely to calculate tax obligations to the government.
IRS Tax Treatment of Leases
The IRS generally classifies leases as being one of two types – True Leases (also known as True Tax Leases) and Non-Tax Leases. The primary difference between these two types of leases is discussed below.
True Leases (or True tax Leases):
In a True Lease the lessor is considered to be the owner of the equipment for tax purposes. What that means is that the lessor gets any tax benefits associated with ownership such as using depreciation to lower taxable income. On the other hand, the lessee is considered to be renting the equipment and therefore the lease payment is considered to be rental expense and reduces the taxable income. FMV leases typically qualify as True Leases. For accounting purposes, a True Lease may be treated as an Operating Lease or a Capital Lease depending on the circumstances.
In a Non-Tax Lease, the lessee is considered to be the owner of the equipment and therefore gets to reduce their taxable income by the amount of depreciation and interest expense. Note that the interest expense here is just the interest component of the lease payment and not the entire amount of the lease payment. Non-FMV leases are typically treated as Non-Tax Leases.
Book Accounting Treatment of Leases
The Financial Accounting Standards Board (FASB) establishes the rules to determine whether a lease is treated as an operating lease or a capital lease.
In an operating lease, the owner of the equipment (lessor) transfers only the right to use the equipment to the lessee. At the end of the lease period, the lessee returns the property to the lessor. The equipment leased is generally viewed as a rental. The equipment shows up as an asset on the lessor’s balance sheet and not the lessee’s, i.e., lease obligations are kept off-balance sheet for the lessee. The lease payment is recorded as a rental expense in the lessee’s income statement. FMV leases are generally classified as operating leases and are generally True Leases for tax purposes if they meet all IRS criteria to be classified as a True Lease.
In a capital lease, the lessee assumes some of the risks of ownership. Therefore, the lease is recognized as an asset and the lease payments due are recognized as a liability on the balance sheet of the lessee. The lessee gets to claim depreciation on the asset and also deducts the interest expense component of the lease payment from its operating income. Leases with a bargain purchase option at the end, such as $1, $100 or 10% buyout leases are generally treated as capital leases as the lessee owns the equipment for all practical purposes.
FASB rules treat a lease as capital lease if any one of the following four tests is met:
- The lease conveys ownership to the lessee at the end of the lease term;
- The lessee has an option to purchase the asset at a bargain price at the end of the lease term;
- The term of the lease is 75% or more of the economic life of the asset;
- The present value of the rents, using the lessee’s incremental borrowing rate, is 90% or more of the fair market value of the asset.