Taxes The Irs And Leases

The lessee can deduct lease payments for income tax purposes if the lease is deemed to be a true lease by the Internal Revenue Service. The tax shields associated with lease payments are critical to the economic viability of a lease, so IRS guidelines are an important consideration. Essentially, the IRS requires that a lease be primarily for business purposes and not merely for purposes of tax avoidance.

In broad terms, a lease that is valid from the IRS's perspective will meet the following standards:

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VIII. Topics in Corporate Finance

26. Leasing

© The McGraw-Hill Companies, 2002

CHAPTER 26 Leasing

1. The term of the lease must be less than 80 percent of the economic life of the asset. If the term is greater than this, the transaction will be regarded as a conditional sale.

2. The lease should not include an option to acquire the asset at the end of the lease term at a price below the asset's then-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 are very high at the start of the lease term and thereafter very low. If the lease requires early "balloon" payments, this will be considered evidence that the lease is being used to avoid taxes and not for a legitimate business purpose. The IRS may require an adjustment in the payments for tax purposes in such cases.

4. The lease must survive a profits test, meaning that the lessor must have the reasonable expectation of making a profit without considering income taxes.

5. Renewal options must be reasonable and reflect the fair market value of the asset at the time of renewal. This requirement can be met by, for example, granting the lessee the first option to meet a competing outside offer.

The IRS is concerned about lease contracts because leases sometimes appear to be set up solely to defer taxes. To see how this could happen, suppose that a firm plans to purchase a $1 million bus that has a five-year life for depreciation purposes. Assume that straight-line depreciation to a zero salvage value is used. The depreciation expense would be $200,000 per year. Now suppose 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 is clearly less if the bus is bought than if the bus is leased. The speedup of lease payments greatly benefits the firm and basically gives it a form of accelerated depreciation. In this case, the IRS might decide that the primary purpose of the lease was to defer taxes.

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