|Some Companies still mistakenly think of a lease and a conditional sales contract or a loan as being the same. From a distance, both products look the same, but upon closer examination, due to the difference in the tax treatment, the products are completely different.|
A lease is commonly referred to as a true lease or a tax lease for tax purposes. (The terms operating or capital leases are used to categorize a lease for financial statement purposes and have nothing to do with the tax treatment of a lease.) A lease for Federal Tax purposes treats the lessor as the owner of the asset. The lessor is entitled to all of the tax benefits associated with the ownership of the property. From the lessee perspective, the full amount of the lease payment is deductible as an ordinary and necessary business expense.
The guidelines for establishing the classification of a lease are provided in several Internal Revenue pronouncements and rulings including Revenue Ruling 55-54 and Rev. Proc. 75-21.
The classification of the agreement is very important because of the significance of the tax treatment. The tax treatment affects the cash flows. The business expenses attributable to a true lease are deducted over the term of the lease. Conversely, a conditional sales contract or a loan, expenses the depreciation over the government mandated class life. Due to the difference in the timing of these deductions, the lease can often provide an acceleration of expenses and a deferral of income and consequently tax liability.
Contract A sale, in its truest form, involves the transfer, for consideration by the owner of the asset (the seller) to another party (the buyer) of all the rights to the asset, including ownership and use. In a conditional sales contract, the seller sells the asset and transfers possession to the purchaser, but retains title to the asset until the purchaser has fully paid for it. There cannot be a lease with a $1 buyout. In substance, it is a sale. This type of transaction is considered a conditional sales contract.
If the transaction is deemed a conditional sales contract, the purchaser deducts on its tax return, the depreciation and the interest expense. The Tax Reform Act of 1986 (trA 86) established the method for depreciation that must be adhered to. Modified Accelerated Cost Recovery System (MACRS) is the current depreciation methodology. The tax treatment for a loan is identical to that of a conditional sales contract.