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;