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Your choice of leasing products is directly related to the tax and accounting implications for your business. We've put together information to help you understand leasing product classifications as well as basic terminology to give you the information you need. As always, Key encourages you to consult your tax advisor.
In the United States, the Internal Revenue Service (IRS) and the Financial Accounting Standards Board (FASB) are two separate entities that have an interest in how a lessee and lessor classify a lease transaction. The IRS and FASB have separate methods for classifying and reporting leases. Businesses may choose different lease types to achieve different objectives:
- Tax reporting goal — Minimize taxable income by maximizing tax deductions
- Financial accounting goal — Maximize income and profitability
In order to address different business goals, the leasing industry offers different leasing products: tax reporting leasing products and financial reporting leasing products.
Minimize Taxable Income, Maximize Tax Deductions
Tax Reporting Leasing Products
In classifying the lease as a tax or non-tax lease, the IRS looks at the risks and rewards of equipment ownership. The IRS seeks to determine whether the lease agreement is a tax or non-tax lease based on the apparent intent of the lessee and the lessor at the beginning of the lease.
Tax Lease — In a tax lease, the lessor is the owner of the equipment for federal income tax purposes. The lessor receives the right to the tax benefits of ownership, including depreciation and any tax credits. The lessee also receives a tax benefit by being allowed to claim the entire lease payment as a business expense, thus lowering the businesses' taxable income.
Non-Tax Lease — With a non-tax lease, the IRS treats the lease as if it were a purchase or loan for tax purposes. The lessee receives the tax benefit of ownership, including depreciation.
Maximize Income and Profitability
Financial Reporting Leasing Products
Financial reporting refers to the accounting presentation of leases in the financial statements of lessors and lessees. Financial reporting is strictly defined by rules of the FASB. All leases are classified as either a capital lease or an operating lease for financial reporting purposes.
Capital Lease — The FASB classification of a lease is based upon whether it looks like the lessee is purchasing the equipment or only using it. According to FASB criteria if the basis of the transaction is a purchase of equipment in the form of a lease, it is called a capital lease. The lease is considered a capital lease if the lessee will:
- Acquire the asset
- Use the asset for most of its useful life
- Pay a significant portion of its cost during the lease term
A capital lease is treated the same as a purchase, and the equipment is shown as an asset and a liability on the lessee's business balance sheet.
Operating Lease — If a lessee does not acquire the asset, does not use the asset for most of its useful life, or does not pay a significant portion of its cost during the lease term, the FASB considers the lease an operating lease. The operating lease is accounted for as a pure rental, and the equipment is neither shown as a liability nor an asset on the lessee's business balance sheet. As always, Key encourages you to consult your tax advisor.
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