Equipment Leasing

<div class="Section1">An equipment leasing company may enter into a “wrap lease.” After entering into the basic arrangement between manufacturer and user, and having arranged financing, the equipment leasing company sells the equipment (subject to the user lease and lender’s rights) to an unrelated third party who in turn sells the equipment (still subject to the user lease and lender’s rights) to a partnership or trust. The partnership or trust then <em>leases</em> the equipment (still subject to the user lease and lender’s interest) back to the equipment leasing company. This second lease to the equipment leasing company is generally for a longer term than the leasing company’s underlying lease to the user. This lease from the investors to the leasing company is termed a “wrap lease.” (In effect, the second, longer lease to the leasing company is wrapped around the original lease to the user.) In this arrangement, the leasing company both leases from the partnership, trust, or directly from the investors, and in turn leases to the user. (In other words, the leasing company is a lessor with respect to the user and lessee with respect to the partnership or trust.)</div>

<div class="Section1">Yes.&nbsp;The owner of leased equipment may generally deduct each year amounts paid for interest on indebtedness incurred to purchase the equipment.&nbsp;The interest may be deducted only over the period to which a prepayment relates, not when prepaid.<a href="#_ftn1" name="_ftnref1">¹</a> However, the interest will generally be subject to the passive loss rules (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7902">7902</a>).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect;&nbsp;461(g)(1), 461(h).<br /> <br /> </div></div><br />

<div class="Section1">Yes, the &ldquo;at risk&rdquo; rules will apply unless the investment is in an entity taxed as a C corporation, other than a closely-held corporation (generally, more than 50&nbsp;percent control by 5 or fewer owners).&nbsp;The &ldquo;at risk&rdquo; rules will not apply to a closely-held corporation&rsquo;s equipment leasing activities if 50&nbsp;percent or more of the corporation&rsquo;s gross receipts are attributable to equipment leasing<a href="#_ftn1" name="_ftnref1">¹</a> (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8004">8004</a>).<div class="Section1"><br /> <br /> In general, the &ldquo;at risk&rdquo; rules limit the deduction an investor may claim for the investor&rsquo;s share of net losses generated by an equipment leasing program to the amount he or she has at risk in that program.&nbsp;The rules do not prohibit an investor from offsetting his or her share of the deductions generated by the program against the income received from that program. For a detailed explanation of the operation of the at risk limitation, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8006">8006</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8009">8009</a>.<br /> <br /> Put as simply as possible, an investor is initially &ldquo;at risk&rdquo; to the extent that the investor is not protected against the loss of money or other property he or she contributes to the program. For the specifics as to how an investor&rsquo;s &ldquo;amount at risk&rdquo; is calculated, <em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8005">8005</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; See IRC &sect;&sect;&nbsp;465(a)(1), 465(c)(4).<br /> <br /> </div></div><br />

<div class="Section1">Cash basis taxpayers generally include rental payments in income in the taxable year in which they are actually or constructively received. Leasing programs have sometimes used deferred or stepped rent schedules in order to delay receipt of income until later years of the program, with the effect of increasing loss deductions in early years. However, lessors under certain deferred or stepped payment lease agreements entered into after June&nbsp;8, 1984, are required to report rental income as it accrues, as well as interest on rent accrued but unpaid.<a href="#_ftn1" name="_ftnref1">¹</a> Agreements are subject to this rule if at least one amount allocable to the use of the property during a calendar year is to&nbsp;be paid after the close of the following calendar year, or if there are increases in the amount to be paid as rent under the agreement.&nbsp;This accrual requirement does not apply if the aggregate value of the money and other property received and to be received for use of the property is $250,000 or less.<a href="#_ftn2" name="_ftnref2">²</a>&nbsp;These rules are discussed in further detail in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7831">7831</a>.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;467(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;467(d).<br /> <br /> </div></div><br />

<div class="Section1">The investor may have the following adjustments to alternative minimum taxable income (AMTI) or tax preferences in connection with investment in an equipment leasing program that passes losses and deductions through to the investor:</div><br /> <div class="Section1"><br /> <blockquote>(1)  Passive activity losses (determined by taking into account the adjustments to AMTI and tax preferences) are not allowed in calculating AMTI.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> (2)  Generally, in calculating AMTI, equipment must be depreciated using a 150 percent declining balance method switching to the straight-line method at a time to maximize the deduction over the regular recovery periods.</blockquote><br /> Property is assigned to various <em>class lives</em> in Revenue Procedure 88-22.<a href="#_ftn2" name="_ftnref2">²</a> These class lives can also be found in IRS Publication 946.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 58(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  1988-1 CB 785.<br /> <br /> </div>

<div class="Section1">The equipment leasing business provides equipment to users who want the equipment but, for various reasons, prefer not to purchase it. Ordinarily, the user arranges with an equipment leasing company to have the leasing company buy the equipment from the manufacturer and lease it to the user. The leasing company obtains financing for its purchase and generally secures the loan with a lien against the equipment and an assignment of the flow of rental income to the lender to amortize the loan. The equipment leasing company then sells the equipment (subject to the lease to the user and subject to the rights of the lender) to a limited partnership, a grantor trust, or to individual investors.</div><br /> <div class="Section1"><br /> <br /> In a highly leveraged program, the flow of rental income from the lease is generally used to meet debt service and there is nothing available for cash distributions. These programs anticipate that the debt will be paid off at the expiration of the initial user lease and that the property will have residual value that can be realized through further leasing of the equipment or on the sale of the property. Thus cash distributions are projected for later years. Less highly leveraged programs, or unleveraged programs, are designed to provide for cash distributions to the investors from the start.<br /> <br /> </div>

<div class="Section1">The primary tax benefit of equipment leasing programs is tax deferral. Deductions for depreciation, interest, and expenses offset rental income from the program and, depending on the amount of deductions, may offset income from other sources. Because an equipment leasing program will generally be a passive activity, such excess deductions (losses) may normally offset only other passive income of the taxpayer (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7902">7902</a>).<div class="Section1"><br /> <br /> Depreciation and interest deductions will decline. Consequently, while there may be tax losses in early years that offset income from sources other than the program, in later years the investor will recognize taxable income that may substantially exceed cash available from the program (&ldquo;phantom income&rdquo;).&nbsp;The carryover of disallowed passive losses from earlier years may reduce or even eliminate the phantom income in later years.<br /> <br /> Generally, limited partnerships and S corporations act as flow-through entities, and partners and shareholders report their share of the entity&rsquo;s income, deductions, and credits on their own tax returns (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7732">7732</a>). (Electing large partnerships have somewhat different flow-through rules than regular partnerships (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>).) However, if a publicly traded partnership is taxed as a corporation, the income, deductions, and credits are reported by the partnership and do not flow-through to the partners. Electing 1987 partnerships are subject to both an entity level tax and the flow-through rules. In general, investment in a publicly traded partnership taxed as a corporation will be taxed as an investment in a corporation. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7728">7728</a> for the treatment of publicly traded partnerships.<br /> <br /> </div></div><br />

<div class="Section1">Yes, rental activities will generally be considered passive activities subject to the passive loss rules. Even if substantial services are provided, so that the equipment leasing activity is not considered a rental activity, the investor usually will not materially participate in the program. As a result, the investor in such a program will generally be subject to the passive loss rules (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>). However, an entity taxed as a C corporation typically is not subject to the passive loss rules (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a>).<div class="Section1"><br /> <br /> In general, the rules limit the amount of the taxpayer&rsquo;s aggregate deductions from all passive activities to the amount of aggregate income from all passive activities; passive credits can be taken against only tax attributable to passive activities.&nbsp;The rules are applied separately in the case of a publicly traded partnership; aggregation is permitted only within the partnership.&nbsp;The rules are intended to prevent taxpayers from offsetting salaries, interest, dividends, and other positive income with losses from passive activities.&nbsp;The benefit of the disallowed passive losses and credits is not altogether lost, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>).<br /> <br /> </div></div><br />

<div class="Section1">The amount realized on the sale or other disposition of property in excess of adjusted basis is gain; if the amount realized is less than adjusted basis, it is loss.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The basis of property is generally its cost reduced by the portion of cost which the taxpayer elects to treat as an expense (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7895">7895</a>) and by the basis adjustment attributable to any investment tax credit (<em><em>see</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7894">7894</a>).<a href="#_ftn2" name="_ftnref2">²</a> Also, the basis is reduced each year by the amount of the depreciation taken so that the <em>adjusted</em> basis in the property reflects accumulated depreciation deductions. If depreciation is not deducted, the basis must nonetheless be reduced by the amount of depreciation allowable.<a href="#_ftn3" name="_ftnref3">³</a> If the investment tax credit is recaptured in connection with property as to which a basis adjustment was required, then the basis is increased by such recaptured amount.<a href="#_ftn4" name="_ftnref4">⁴</a><div class="Section1"><br /> <br /> Where leased equipment has been depreciated, gain on the sale of the property must be treated as ordinary income to the extent of all depreciation deductions allowed.<a href="#_ftn5" name="_ftnref5">⁵</a>&nbsp;The gain in excess of the recaptured ordinary income is &ldquo;IRC Section&nbsp;1231&rdquo; gain; loss is &ldquo;IRC Section&nbsp;1231&rdquo; loss. <em><em>See</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7834">7834</a> for an explanation of the treatment of IRC Section&nbsp;1231 gains and losses. <em><em>See</em> </em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="667">667</a> if the equipment is sold on the installment method.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;1001.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect;&nbsp;1012, 1016(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;1016(a).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;50(c)(2).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect;&nbsp;1245.<br /> <br /> </div></div><br />

<div class="Section1">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.&nbsp;The courts have used various tests that look at facts and circumstances to determine whether the arrangement is a lease or sale.&nbsp;The IRS has published some guidelines as to what it looks for when determining whether a transaction constitutes a lease.&nbsp;The courts have indicated that something less than what is set out in the guidelines may be acceptable but have otherwise provided little guidance. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7892">7892</a> for a discussion of court decisions impacting this determination.<br /> <p style="text-align: center;"><strong>IRS Guidelines</strong></p><br /> 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 &ldquo;light of the facts and circumstances existing at the time the agreement was executed.&rdquo;<a href="#_ftn1" name="_ftnref1">¹</a> Some factors indicating a conditional sale include:<br /> <p style="padding-left: 40px;">(1)&nbsp; 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;</p><br /> <p style="padding-left: 40px;">(2)&nbsp; passage of title to the lessee after the payment of a stated amount of rentals;</p><br /> <p style="padding-left: 40px;">(3)&nbsp; 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;</p><br /> <p style="padding-left: 40px;">(4)&nbsp; 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;</p><br /> <p style="padding-left: 40px;">(5)&nbsp; acquisition of equity by the lessee through &ldquo;rental&rdquo; payments;</p><br /> <p style="padding-left: 40px;">(6)&nbsp; rental payments that exceed the current fair rental value;</p><br /> <p style="padding-left: 40px;">(7)&nbsp; 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;</p><br /> <p style="padding-left: 40px;">(8)&nbsp; a purchase option that is nominal when compared to the total payments to be made; and</p><br /> <p style="padding-left: 40px;">(9)&nbsp; a portion of the periodic payments that is interest or equivalent to interest.</p><br /> If even stricter requirements are met, the lessor in a leveraged lease transaction (other than for &ldquo;limited use&rdquo; 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.&nbsp;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.<a href="#_ftn2" name="_ftnref2">²</a>&nbsp;The requirements are:<br /> <p style="padding-left: 40px;">(1)&nbsp; 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&nbsp;percent of the cost of the property.&nbsp;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.</p><br /> <p style="padding-left: 40px;">(2)&nbsp; The lessor must also maintain a minimum unconditional at risk investment at the end of the lease term.&nbsp;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&nbsp;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&nbsp;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.</p><br /> <p style="padding-left: 40px;">(3)&nbsp; Purchase and sale rights to the property must be restricted to some extent. A member of the &ldquo;lessee group&rdquo; (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.&nbsp;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.</p><br /> <p style="padding-left: 40px;">(4)&nbsp; 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 (&ldquo;improvements&rdquo;) with certain exceptions:</p><br /> <p style="padding-left: 80px;">(a)&nbsp; 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 (&ldquo;severable improvement&rdquo;).&nbsp;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.&nbsp;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.</p><br /> <p style="padding-left: 80px;">(b)&nbsp; 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 (&ldquo;nonseverable improvement&rdquo;) only if certain conditions are met:</p><br /> <p style="padding-left: 120px;">(i)<br /> The improvement must not be necessary to make the property complete for its intended use by the lessee.</p><br /> <p style="padding-left: 120px;">(ii)<br /> 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.</p><br /> <p style="padding-left: 120px;">(iii)<br /> The improvement must not cause the property to become limited use property (<em><em>see</em></em> heading &ldquo;Limited Use Property&rdquo; below).</p><br /> <p style="padding-left: 120px;">(iv)<br /> 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&nbsp;percent over that when first placed in service, nor &ldquo;modify the leased property for a materially different use.&rdquo;</p><br /> <p style="padding-left: 120px;">(v)<br /> A de minimis rule exists exempting certain improvements totaling not in excess of 10&nbsp;percent of the cost of the property.&nbsp;This is calculated with an adjustment for inflation.</p><br /> <p style="padding-left: 80px;">(c)&nbsp; Maintenance and repairs required under the lease will not be treated as an improvement furnished by a member of the lessee group.</p><br /> <p style="padding-left: 80px;">(d)&nbsp; The lease may provide adjustment for cost overruns.</p><br /> <p style="padding-left: 40px;">(5)&nbsp; A member of the lessee group may not lend a lessor funds to acquire the property, nor may the member guarantee a lessor&rsquo;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&rsquo;s obligation to pay rent, to maintain property, or to pay insurance premiums or similar obligations of a net lease.</p><br /> <p style="padding-left: 40px;">(6)&nbsp; A lessor must demonstrate that it expects to profit from the lease, apart from tax benefits.&nbsp;This must be shown by an overall profit and a positive cash flow.&nbsp;To show an overall profit, rental payments from the property plus the residual investment in the property must exceed the sum of the lessor&rsquo;s disbursements in connection with the property and the lessor&rsquo;s equity investment in the property. Direct costs of financing the equity investment are included in the equity investment.&nbsp;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.</p><br /> The requirements set out in Revenue Procedure 2001-28 were effective May&nbsp;7, 2001. Prior to May&nbsp;7, 2001, the requirements for advanced rulings were governed by Revenue Procedure 75-21,<a href="#_ftn3" name="_ftnref3">³</a> the requirements of which were similar to those in Revenue Procedure 2001-28.<br /> <p style="text-align: center;"><strong>Limited Use Property</strong></p><br /> 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.&nbsp;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&rsquo;s useful life.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Rev. Rul. 55-540, 1955-2 CB 39.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Rev. Proc. 2001-28, 2001-1 CB 1156.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; 1975-1 CB 715.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Rev. Proc. 2001-28, 2001-1 CB 1156.<br /> <br /> </div></div><br />