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">Terminal rental adjustment clauses will be disregarded for purposes of lease characterization in the case of a qualified motor vehicle operating agreement.<a href="#_ftn1" name="_ftnref1">¹</a> A terminal rental adjustment clause is a provision that calls for an additional payment by the lessee if the lessor is not able to obtain a stated amount upon the sale or other disposition of the property at the end of the lease term or a payment by the lessor if the lessor is able to obtain more than the stated amount. Terminal rental adjustment clauses also include provisions requiring a “lessee who is a dealer in motor vehicles to purchase the motor vehicles at a predetermined price and then resell such vehicle where such provision achieves substantially the same results.”<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> A qualified motor vehicle operating agreement is an agreement with respect to a motor vehicle (including a trailer) that meets the following requirements: (1) the sum of the lessor’s recourse liability with regard to the lease and the net fair market value of property pledged as security for the leased property (other than property subject to the lease or financed directly or indirectly by property subject to the lease) must be greater than or equal to the amount borrowed to acquire the property subject to the lease, (2) the lessee must supply a sworn statement that the lessee intends for more than 50 percent of the use of the property to be in the trade or business of the lessee and that the lessee is aware he or she will not be treated as owner of the property for federal income tax purposes, and (3) the lessor must not have knowledge that the lessee’s sworn statement is false.<a href="#_ftn3" name="_ftnref3">³</a><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 § 7701(h)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 7701(h)(3).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 7701(h)(2).<br /> <br /> </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 />