1.	What is a lease? A lease is a contract. By its terms, one party (the "lessor") gives another (the "lessee") the exclusive right to use and possess its property or equipment (the "leased property" or "leased equipment") for a specified period. Equipment leasing has become an accepted and economical source of financing. A lease can finance the acquisition of equipment or act as an additional source of working capital. In this respect, it acts as an alternative to traditional debt financing. The lease contract may evidence a single transaction involving a specific term or items of equipment, or it may be written as a "master" lease governing a continuing arrangement, with the specific descriptions of equipment evidenced by separate schedules executed from time to time. In either case, the contract will require the lessee to make periodic payments (or "rentals") to the lessor for the use of the leased equipment. Where a lease is used as a source of financing, it is typically a long-term arrangement in which the lessee has a non-cancelable "hell or high water" obligation to pay rentals. Such leases will contain contractual provisions requiring the lessee to pay all taxes, insurance premiums, maintenance costs and other expenses relating to the equipment during the lease term (a "net" lease). Because the equipment is in the lessee's possession and control, the lease will provide that the lessee bears all risk of loss or damage. Further, the lessor will disclaim all warranties, and the lessee will waive its right to assert any claims or defenses against the lessor for any problems with the equipment. However, the lessor should assign to the lessee any warranties and other rights against the manufacturer or vendor. Many different types of equipment leases are discussed in this booklet. The decision to lease or buy equipment will involve various considerations, such as cash flows, economics, tax and accounting implications. These considerations will also be explained. Once a decision to lease has been made, the lease arrangement can be structured in a variety of ways to suit the needs of the lessee. Many of these structuring alternatives will be mentioned. Although individuals may lease consumer goods (such as a family car), this booklet will focus on leases of commercial and industrial equipment for use by business entities.
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2.	Who can lease? Any individual, sole proprietorship, partnership, corporation (including a nonprofit corporation or S corporation) or trust may be a lessee under a lease agreement. With certain exceptions and restrictions, even the federal government, a state, a county, a school board or a municipality, as well as foreign individuals and entities, may be a lessee under a lease.
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3.	What types of equipment qualify? All new or used tangible property subject to depreciation (i.e., which remains useful after the year it was purchased) used in a trade or business or held for the production of income can be leased. Some examples are: cars, trucks, tractors and trailers construction equipment aircraft (both fixed-wing and helicopters) machine tools and industrial equipment telecommunications systems and related equipment computer systems and data processing equipment broadcasting and CATV equipment furniture, fixtures and office equipment medical equipment electronics equipment printing equipment However, special use or "limited use" property (property of no use to anyone other than the lessee or a related party) is not eligible under Internal Revenue Service ("IRS") guidelines for a tax-oriented lease.
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4.	What is a tax-oriented lease? A tax-oriented lease is a lease under which the lessor will be treated by the IRS as the owner of the leased property for federal tax purposes and permitted to take tax benefits (eg., depreciation deductions on the leased property). All rentals paid by a lessee under a tax-oriented lease are deductible for federal tax purposes. Tax oriented leases are sometimes referred to as "true leases". These leases are also generally referred to as "guideline leases"; unless the lease contains a terminal rental adjustment clause, which causes it to be referred to as a "TRAC lease". Not all agreements labeled "lease agreements" are treated as tax-oriented leases by the IRS. Lease agreements which are not treated as tax-oriented leases are treated as conditional sale contracts or loans and referred to as "non-tax-oriented leases" or "quasi-leases". Given that a lessor takes advantage of the tax benefits under a tax-oriented lease, a lessor should be able to offer lower rental payments to the lessee than under a non-tax-oriented lease.
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5.	What is a guideline lease? A guideline lease complies with all of the IRS requirements (or "guidelines") for a true lease; specifically, those set forth in Rev. Proc. 75-21, 75-28, 76-30 and 7948. In general, these guidelines include, but are not limited to: The lease term (including any extensions or renewals at a predetermined fixed rental) must not exceed 80% of the estimated useful life of the equipment at the commencement of the lease transaction. Thus, the equipment must be projected to have an estimated remaining useful life equal to at least 20% of its original life at the end of the lease. These requirements limit the maximum term of the lease. The equipment's estimated residual value (in constant dollars without adjustment for inflation or deflation) at the expiration of the lease term must, at lease commencement, be projected to equal at least 20% of its original value. This requirement also limits the maximum lease term. Neither the lessee nor any related party can have a right to purchase the property from the lessor at a price less than its fair market value at the time of the purchase. Thus, the lessee cannot be given any option to purchase the equipment at a bargain purchase price. However, the lessee can be given a fair market value purchase option. Neither the lessee nor any related party can pay, or guarantee payment of, any part of the price of the leased equipment. Simply put, the lessee cannot make any investment in the equipment. That's why tax-oriented leasing is deemed to be 100% financing. The leased equipment must not be "limited use" property. Equipment is limited use property if no one other than the lessee or a related party could use it in a commercially feasible manner at the end of the lease.
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6.	What is a TRAC lease? Tax-oriented leases, of qualified motor vehicles and trailers, with terminal rental adjustment clauses ('TRACs") are referred to as TRAC leases. TRAC leases were introduced in 1982 by the Tax Equity and Fiscal Responsibility Act ("TEFRA"). A TRAC lease must meet all of the requirements for a guideline lease, except for the TRAC provisions. A TRAC permits or requires an adjustment of rentals according to the amount realized by the lessor upon a sale of the leased equipment. For example, at the commencement of the lease term the parties agree upon an amount (sometimes called the "TRAC amount"). If at lease expiration the equipment sells for more than the TRAC amount, the lessee obtains a rebate of rent equal to some or all of the excess sales proceeds. However, if the equipment sells for less than the TRAC amount, the lessee must pay additional rent equal to some or all of the deficiency. TRAC provisions can benefit the lessee in two ways. First, they allow the lessee to share in the residual sales value of the equipment. Second, because the lessee effectively guarantees the equipment's residual value, the rentals to be paid during the lease term may be lower than otherwise available. In connection with all TRAC leases, the tax laws require the lessee to sign a certification statement that it will use the equipment at least 50% of the time in its trade or business and that it has been advised it will not be treated as the owner for federal tax purposes. Furthermore, the tax laws do not allow TRAC provisions in any tax-oriented lease other than a lease of an over-the-road motor vehicle or trailer and do not permit such provisions in any leveraged lease. Although discussions covering modification or elimination of TRAC-related provisions have taken place, there were no indications of pending legislation in that regard at the time this booklet was prepared.
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7.	What is a non-tax-oriented lease? Generally, a non-tax-oriented lease is any lease that is neither a "guideline lease" nor a "TRAC lease". Because it is not a lease for tax purposes, it need not comply with any IRS guidelines. On the lessee's and lessor's tax returns, a non-tax-oriented lease is treated like a loan. Thus, the lessee can deduct only the "interest portion" of each rental payment. Furthermore, because a non-tax-oriented lease is treated like a loan, the tax benefits are not available to the lessor. Therefore, the lessee may take depreciation deductions on the leased equipment. Consequently, the rental payments are usually higher than in a tax-oriented lease. (Also note Question 22.)
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8.	Can leasing help "cash flow"? "Cash flow" is the normal flow of cash into and out of your business. Increasing cash flow may simply mean reducing payments to be made by your business. Whether a tax-oriented lease has fixed rental payments or floating rental payments tied to an interest rate index, a lease can help because rental payments are usually less than debt financing payments. This represents a real cash savings. Often, leasing companies assume that equipment will have a residual resale value at the end of the lease and reduce the rental payments accordingly. This too produces a real cash savings. Finally, a tax-oriented lease can help an AMT taxpayer avoid additional minimum taxes, which would otherwise be due if the taxpayer owned the equipment. MACRS depreciation creates tax preferences (the depreciation preference) but lease payments or rentals do not. This avoidance of minimum tax liability may be a real current cash savings, which is especially important because all taxpayers must pay their estimated minimum tax liability to the IRS on a quarterly basis.
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9.	Is there a down payment? Leasing is generally considered 100% financing, with the leasing company paying the entire purchase price of the asset and leasing it to the lessee with no down payment. Tax-oriented leasing requires the lessor to pay the full purchase price without any participation by lessee. However, in non-tax-oriented leases the lessee may be required to make a down payment. Leases with relatively higher risks for the lessor may require additional security. Additional security could take the form of advance rentals, a pledge of assets or a bank letter of credit.
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10.	How are lease payments structured? Lease payments may be fixed or floating, paid in advance or in arrears, and may even be structured to occur at irregular intervals. Most leases are written with regular monthly or quarterly payments, although this is not a requirement. Floating rate leases may be structured in a variety of ways, from payments that fluctuate monthly, quarterly or annually to fixed payments with periodic adjustments for changes in an index (e.g., three year T-Bills). A lease may also provide for different levels of periodic rentals for specified portions of the lease term. Although the IRS guidelines do not restrict the amount that one year's rentals might vary from rentals in another year, "normalization" of rents may be required by the lessee or the lessor if the "level rent test" guideline is not satisfied. (See Rev. Proc. 75-21 and 75-28. Also see Internal Revenue Code Section 467.) In a "high-low" rent structure (rentals higher for one period of time than a following period), the lessee may be required for tax purposes to claim rental deductions as though all rents were level throughout the lease term. This results in a deferral of rental deductions from one or more early years to the later years and is referred to as "normalizing" rents. Conversely, a lessor may be required to normalize its recognition of taxable rental income in certain "low-high" rent structures where rentals are lower for one period of time than for a following period. Such normalization of rents would require the lessor to recognize taxable rental income before the rentals are actually received (so-called "phantom income"). The "level rent test" includes several different structure option provisions. These enable a lease agreement to satisfy the IRS guideline as well as Section 467 and vary rents to meet many different situational needs. Since some of the substantive provisions of Section 467 have been left to future regulations, this test should be reviewed prior to entering into a lease agreement.
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11.	Can payments be adapted to seasonal cash flow needs? Yes. Some industries experience predictable irregular cash flows and/or seasonal slowdowns due to weather conditions, market conditions or a variety of other reasons. The impact of weather on the construction industry is just one example. For such businesses, leases may be arranged with payments due at irregular times, such as monthly from April to November only, in concert with the productive use of equipment. Special care is needed in calculating the effective rate when irregular payments are involved. Each payment should be discounted the exact number of calendar months it occurs after the start of the lease. Federal income tax impact of uneven rentals, which may have to be expensed on an even or "normalized" basis, may also be a factor. Lessors should be expected to provide payment structures that address lessees' needs, in any case.
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12.	What can be done to lower lease payments? Periodic (e.g., monthly or quarterly) lease rentals may be lowered by negotiating changes in the term, payment structure or, for a TRAC lease, the TRAC amount. Extending the term. The longer the lease term, assuming level rentals, the lower the periodic payment. However, your aggregate rentals will naturally be higher over the longer period. Changing the structure. By changing to an uneven or irregular payment schedule, payments may be lowered during periods when your business prefers lower cash outflows. Increasing the TRAC amount. In a TRAC lease (a lease of motor vehicles or trailers that complies with the requirements of the tax laws), the lessee can guarantee to the lessor that the equipment will sell for a specified amount (the TRAC amount) at the expiration of the lease term. This guarantee may allow the lessor to assume a higher residual value, and thereby reduce the amount of rent to be paid during the lease term. Such guarantees are not permissible, according to IRS guidelines, for tax-oriented leases that are not TRAC, leases of qualified motor vehicles or trailers.
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13.	Is there a maximum lease term? Generally, tax-oriented leases are limited to a maximum of 80% of the asset's estimated useful life, where "estimated useful life" is an industry norm or is determined by an objective third-party appraisal. The leased equipment must also be expected to retain at least 20% of its original value, without adjustment for inflation or deflation, at lease expiration. For these tests, any renewal at a predetermined rental is generally included as part of the lease term. Similar tests are imposed for capital versus operating leases under FASB 13.
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14.	Can I renew or extend a lease? True leases may provide for extensions as long as the sum of the basic lease term and all renewal periods with predetermined rentals does not exceed the maximum allowed by the IRS. Renewals at the then fair market rental value do not have to be considered in applying the IRS test. Of course, these limitations do not apply to non-tax-oriented leases. Tax-oriented leases sometimes have employed an "evergreen" renewal clause to derive the maximum use of the equipment for the lessee while remaining within the IRS guidelines for maximum lease term. Such a clause ordinarily grants the lessee a right to renew the lease at a fixed rate predetermined at lease commencement. However, an updated appraisal at the end of the primary term and subsequent renewal periods must demonstrate that, at the end of the extended term, the equipment would still have at least 20% remaining useful life and value. The improper use of such clauses, however, may invite a challenge by the IRS.
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15.	Can I get out early? All leases are subject to early termination in the event of a casualty, such as loss or irreparable damage to the equipment. For such a situation, leases contain provisions for a "casualty value" or "stipulated loss value" payment to the lessor which is intended to close out the transaction. The parties may also negotiate termination options, which give the lessee a right to terminate (usually after a specified minimum term) if the equipment becomes obsolete or surplus to the lessee's needs, by finding a third-party buyer for the equipment. If the buyer purchases for a price less than the "termination value", the lessee is obligated to pay the deficiency to the lessor. In some cases, the lessee may also be given the right to terminate the lease and buy the equipment for its fair market value or terminate by making a termination payment, returning equipment, and not being involved in remarketing.
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16.	Can I make improvements to leased equipment? In a tax-oriented lease, the IRS guidelines prohibit the lessee (or a related party) from making any investment in the leased equipment. Under these rules, the lessee is not deemed to have made any investment if it pays for the cost of a "severable improvement". A severable improvement is one that is readily removable without material damage to the equipment and is not required to render the equipment complete for its original intended use by the lessee. All other improvements are considered nonseverable. Generally, the IRS guidelines prohibit the lessee (or a related party) from paying for any such improvement. For this reason, these improvements are often paid for by the lessor and are leased to the lessee. The lease term of the improvements is usually coterminous (ending on the same date) with the lease term of the equipment. Obviously, these restrictions do not apply to a non-tax-oriented lease.
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17.	Can I have the right to purchase the equipment? Yes. The IRS guidelines do not allow purchase options below fair market value. Consequently, tax-oriented leases generally allow lessees to purchase equipment for its "fair market value" at the expiration of the basic lease term or renewals. Earlier purchase options at a fair market value amount may also be included in a given lease contract.
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18.	What is a "fair market value" purchase option? A "fair market value purchase option" gives the lessee the opportunity to purchase the equipment for its fair value (a price determined in an arms-length transaction). The price, if not agreed upon by the lessor and lessee at the time the option is exercised, is usually determined at such time by an appraiser or independent third-party, as specified in the lease contract.
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19.	What is a sale-leaseback? A sale-leaseback is an arrangement whereby the owner of equipment agrees to sell that equipment and immediately lease it back. Prior to the sale-leaseback, this equipment may be subject to a security interest of another party. In that case, the secured lender is usually paid off at the time of the sale. Most states have laws which directly affect sale-leasebacks. These laws could require special forms of public notice and could even treat the transaction as a fraudulent conveyance. Seller/lessees, to avoid problems, should make sure that their buyer/lessor works with them to identify and avoid, wherever possible, any adverse consequences.
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20.	What are the advantages of a sale-leaseback? A sale-leaseback of equipment and/or other tangible personal property generates cash, improving liquidity; converts hidden equity into cash assets as well as profits; frequently improves financial statements and important measurement ratios; creates an additional source of capital; and avoids use of valuable cash and available bank lines. Additionally, a sale-leaseback may help the lessee avoid or reduce liability for minimum tax. Tax-oriented leasing, unlike ownership, does not create tax preference items for minimum tax purposes. The changing of regular and tentative minimum tax positions may cause taxpayers to revisit the use of leasing, rather than maintaining ownership of all assets subject to accelerated depreciation. Gains on sale in a sale-leaseback may, defacto, cause reductions in loss or credit carry forwards, thereby assisting projections of deferred tax asset realization. 'Failure to adequately project such realization would result in a current period earnings adjustment. Therefore, the creation of capital gains through a sale-leaseback can also help minimize or potentially eliminate the carry forward concerns raised through FASB 109.