Taxes, theirs , and leases

The lessee can deduct lease payments for income tax purposes if the lease is qualified by the Internal Revenue Service (the IRS). Because tax shields are critical to the economic viability of any lease, all interested parties generally obtain an opinion from the IRS before agreeing to a major lease transaction. The opinion of the IRS will reflect the following guidelines:

1. The term of the lease must be less than 30 years. If the term is greater than 30 years, the transaction will be regarded as a conditional sale.

2. The lease should not have an option to acquire the asset at a price below its fair market value. This type of bargain option would give the lessee the asset's residual scrap value, implying an equity interest.

3. The lease should not have a schedule of payments that is very high at the start of the lease term and thereafter very low. Early balloon payments would be evidence that the lease was being used to avoid taxes and not for a legitimate business purpose.

4. The lease payments must provide the lessor with a fair market rate of return. The profit potential of the lease to the lessor should be apart from the deal's tax benefits.

5. The lease should not limit the lessee's right to issue debt or pay dividends while the lease is operative.

6. Renewal options must be reasonable and reflect the fair market value of the asset. This requirement can be met by granting the lessee the first option to meet a competing outside offer.

The reason the IRS is concerned about lease contracts is that many times they appear to be set up solely to avoid taxes. To see how this could happen, suppose that a firm plans to purchase a $1 million bus that has a five-year class life. Depreciation expense would be $200,000 per year, assuming straight-line depreciation. Now suppose that the firm can lease the bus for $500,000 per year for two years and buy the bus for $1 at the end of the two-year term. The present value of the tax benefits from acquiring the bus would clearly be less than if the bus were leased. The speedup of lease payments would greatly benefit the firm and de facto give it a form of accelerated depreciation. If the tax rates of the lessor and lessee are different, leasing can be a form of tax avoidance.

Words you may need:

Internal Revenue Service – департамент податків та зборів

to deduct – утримувати, зменшувати

shield – захист, захисний засіб

viability – життєздатність

opinion – висновок фахівця

acquire – набувати, придбавати

residual scrap value – залишкова вартість

to imply – означати, мати на увазі

schedule – графік, план

evidence – доказ

renewal – відновлення

appear – бути доказом