7891 / What IRS guidelines apply in determining whether an equipment leasing arrangement will be treated as a lease or a sale?

It is essential that the leasing arrangement be treated, for tax purposes, as a lease rather than a financing arrangement for a sale (or conditional sale) of the equipment, in order for the investor (or partnership or S corporation) to be considered owner of the equipment and eligible to deduct depreciation and other expenses, as well as to claim the investment tax credit, if available. The courts have used various tests that look at facts and circumstances to determine whether the arrangement is a lease or sale. The IRS has published some guidelines as to what it looks for when determining whether a transaction constitutes a lease. The courts have indicated that something less than what is set out in the guidelines may be acceptable but have otherwise provided little guidance. See Q 7892 for a discussion of court decisions impacting this determination.

IRS Guidelines

According to the IRS guidelines, the intent of the parties as to the nature of the arrangement is to be determined by examining the agreement in “light of the facts and circumstances existing at the time the agreement was executed.”¹ Some factors indicating a conditional sale include:

(1)  rentals for a short period of time relative to the life of the equipment, during which time the rent covers the normal purchase price plus interest;

(2)  passage of title to the lessee after the payment of a stated amount of rentals;

(3)  passage of title to the lessee after a payment at the termination of the agreement which, when added to rental payments, approximates the normal purchase price plus interest;

(4)  payment of substantial rent over a short period of time relative to the life of the equipment, followed by payment of insignificant rent for use of the equipment over the balance of the useful life;

(5)  acquisition of equity by the lessee through “rental” payments;

(6)  rental payments that exceed the current fair rental value;

(7)  a purchase option that is nominal relative to the value of the property at the time when it may be exercised, as viewed from the time of entering into the agreement;

(8)  a purchase option that is nominal when compared to the total payments to be made; and

(9)  a portion of the periodic payments that is interest or equivalent to interest.

If even stricter requirements are met, the lessor in a leveraged lease transaction (other than for “limited use” property) can obtain from the IRS an advance ruling recognizing the lease as such unless all the facts and circumstances indicate a contrary intent by the parties. These requirements do not define whether a transaction is a lease or not for income tax purposes, and are not intended to be used for audit purposes. If these requirements are not met, the IRS will consider ruling in appropriate cases on the basis of the facts and circumstances.² The requirements are:

(1)  A minimum, unconditional, at risk investment must be made by the lessor. At the beginning of and during the term of the lease, this investment must be equal to at least 20 percent of the cost of the property. The lease term includes all renewal or extension periods except for a renewal or extension at the option of the lessee that is for a fair rental value at the time of renewal or extension.

(2)  The lessor must also maintain a minimum unconditional at risk investment at the end of the lease term. This is measured in two ways. First, a reasonable estimate of what will be the fair market value of the property at the end of the lease term must be equal to at least 20 percent of the cost of the property. Additionally, the remaining useful life of the property at the end of the lease term must be the greater of one year or 20 percent of the originally estimated useful life. Fair market value must be determined without including adjustments for inflation or deflation, and after subtracting from the fair market value the cost to the lessor for removal and delivery of the property to the lessor at the end of the lease term.

(3)  Purchase and sale rights to the property must be restricted to some extent. A member of the “lessee group” (the lessee and others related to the lessee) must have no option to purchase the property at a price that is lower than fair market value at the time the option is exercised. A lessor may not have, at the time the property is first placed in use, a contractual right to require any person to purchase the property. The lessor must also state that he or she has no intention to acquire such a right. A subsequent acquisition of such a right could require a redetermination of lease characterization. A right to abandon the property to another person is treated as the right to require that person to purchase the property.

(4)  A member of the lessee group may not furnish any part of the cost of the property or the cost of improvements, modifications, or additions to the property (“improvements”) with certain exceptions:

(a)  A member of the lessee group may pay the cost of an improvement that is owned by the lessee if it is readily removable without causing material damage to the leased property (“severable improvement”). The improvement may not be subject to a contract or option for purchase or sale between the lessor and the lessee at other than fair market value as determined at the time of sale. The improvement must not be necessary to make the property complete for its intended use at the beginning of the lease, unless it is of a kind customarily furnished by lessees of property of the kind leased. For example, a vessel would not be considered complete without a boiler, but would be considered complete without ancillary items such as radar, lines, or readily removable fittings.

(b)  A member of the lessee group may pay the cost of an improvement that is not readily removable without causing material damage to the property (“nonseverable improvement”) only if certain conditions are met:

(i)
The improvement must not be necessary to make the property complete for its intended use by the lessee.

(ii)
A member of the lessee group may not be compensated directly or indirectly for his or her interest in the improvement. For example, a lessor must not be required to purchase the improvement or to reimburse a member of the lessee group for the improvement; option prices or renewal rental rates must not be adjusted to reflect the improvement; and the lessor must not be required to share with a member of the lessee group proceeds from sale or lease of the property to a third party.

(iii)
The improvement must not cause the property to become limited use property (see heading “Limited Use Property” below).

(iv)
Unless the improvement is furnished to comply with health, safety, or environmental standards of a government, it must neither increase the productivity or capacity of the property to more than 125 percent over that when first placed in service, nor “modify the leased property for a materially different use.”

(v)
A de minimis rule exists exempting certain improvements totaling not in excess of 10 percent of the cost of the property. This is calculated with an adjustment for inflation.

(c)  Maintenance and repairs required under the lease will not be treated as an improvement furnished by a member of the lessee group.

(d)  The lease may provide adjustment for cost overruns.

(5)  A member of the lessee group may not lend a lessor funds to acquire the property, nor may the member guarantee a lessor’s indebtedness incurred in connection with the acquisition of the property. An exception applies to guarantees by a member of the lessee group of the lessee’s obligation to pay rent, to maintain property, or to pay insurance premiums or similar obligations of a net lease.

(6)  A lessor must demonstrate that it expects to profit from the lease, apart from tax benefits. This must be shown by an overall profit and a positive cash flow. To show an overall profit, rental payments from the property plus the residual investment in the property must exceed the sum of the lessor’s disbursements in connection with the property and the lessor’s equity investment in the property. Direct costs of financing the equity investment are included in the equity investment. To show positive cash flow, the rental payments from the property over the lease term must exceed by a reasonable amount the disbursements in connection with the property.

The requirements set out in Revenue Procedure 2001-28 were effective May 7, 2001. Prior to May 7, 2001, the requirements for advanced rulings were governed by Revenue Procedure 75-21,³ the requirements of which were similar to those in Revenue Procedure 2001-28.

Limited Use Property

The IRS will not issue rulings concerning whether transactions are leases when the property is limited use property. Limited use property is property that is not expected to have any use to the lessor at the end of the lease term except through continued leasing or sale to a member of the lessee group. The reason given by the Service is that the lessee group will enjoy all the rights of use or ownership for substantially all of the property’s useful life.⁴