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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:

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 Јfair 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 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. 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.

CONCEPT QUESTIONS

Why is the IRS concerned about leasing?

What are some of the standards the IRS uses in evaluating a lease?

The Cash Flows from Leasing

To begin our analysis of the leasing decision, we need to identify the relevant cash flows. The first part of this section illustrates how this is done. A key point, and one to watch for, is that taxes are a very important consideration in a lease analysis.

THE INCREMENTAL CASH FLOWS

Consider the decision confronting the Tasha Corporation, which manufactures pipe. Business has been expanding, and Tasha currently has a five-year backlog of pipe orders for the Trans-Missouri Pipeline.

The International Boring Machine Corporation (IBMC) makes a pipe-boring machine that can be purchased for $10,000. Tasha has determined that it needs a new machine, and the IBMC model will save Tasha $6,000 per year in reduced electricity bills for the next five years.

Tasha has a corporate tax rate of 34 percent. For simplicity, we assume that five-year straight-line depreciation will be used for the pipe-boring machine, and, after five years, the machine will be worthless. Johnson Leasing Corporation has offered to lease the same pipe-boring machine to Tasha for lease payments of $2,500 paid at the end of each of the next five years. With the lease, Tasha would remain responsible for maintenance, insurance, and operating expenses.3

Susan Smart has been asked to compare the direct incremental cash flows from leasing the IBMC machine to the cash flows associated with buying it. The first thing she realizes is that, because Tasha will get the machine either way, the $6,000 savings will be realized whether the machine is leased or purchased. Thus, this cost savings, and any other operating costs or revenues, can be ignored in the analysis. Upon reflection, Ms. Smart concludes that there are only three important cash flow differences between leasing and buying:4

1. If the machine is leased, Tasha must make a lease payment of $2,500 each year. However, lease payments are fully tax deductible, so the aftertax lease payment would be $2,500 _ (1 _ .34) _ $1,650. This is a cost of leasing instead of buying.

2. If the machine is leased, Tasha does not own it and cannot depreciate it for tax purposes. The depreciation would be $10,000/5 _ $2,000 per year. A $2,000 depreciation deduction generates a tax shield of $2,000 _ .34 _ $680 per year. Tasha loses this valuable tax shield if it leases, so this is a cost of leasing.

3. If the machine is leased, Tasha does not have to spend $10,000 today to buy it. This is a benefit from leasing. The cash flows from leasing instead of buying are summarized in Table B.2. Notice that the cost of the machine shows up with a positive sign in Year 0. This is a reflection of the fact that Tasha saves the initial $10,000 equipment cost by leasing instead of buying.

A NOTE ON TAXES

Susan Smart has assumed that Tasha can use the tax benefits of the depreciation allowances and the lease payments. This may not always be the case. If Tasha were losing money, it would not pay taxes and the tax shelters would be worthless (unless they could be shifted to someone else). As we mentioned before, this is one circumstance under which leasing may make a great deal of sense. If this were the case, the relevant lines in Table B.2 would have to be changed to reflect a zero tax rate.

CONCEPT QUESTIONS

What are the cash flow consequences of leasing instead of buying?

Explain why the $10,000 in Table B.2 has a positive sign.