The U.S. Tax Court was the site of a major decision pertaining to a dispute between a leasing company and the IRS. The case was heard more than 40 years ago, but the standard used to determine the victor still applies today.

The U.S. Tax Court was the site of a major decision pertaining to a dispute between a leasing company and the IRS. The case was heard more than 40 years ago, but the standard used to determine the victor still applies today.

Lease-here, pay-here (LHPH) companies are growing in number and many are improperly being told that labeling their leases as “closed-end” affords them significant tax depreciation benefits. Those leases may be ironclad from a legal standpoint, and the lessee may have no wiggle room to break the lease, but the IRS has its own set of rules that must be met as well.

About 30 years ago, when I was getting my master’s degree in taxation, I bought my first CPA practice. I asked the seller what I should say if I’m asked a tax question that I can’t answer. He told me not to worry about my replies. “If the client knew the answer, he wouldn’t have asked the question,” he said. Fortunately for my clients, that is not how I choose to run my practice.

The IRS in Revenue Ruling 55-540 from 1955 (still in effect today) outlined its position on what factors may cause a lease to be recharacterized as a disguised sale. And out of that came six tests to make that determination. If any one of them applies to the lease agreement, then, for tax purposes, it is a disguised sale — specifically, a conditional sales contract. And sales contracts don’t afford the lessor any depreciation rights.

The Six Tests

The first test, applying part of each payment to equity, and the second test, that the lessee acquires title after the set amount of payments are made, don’t really fit an LHPH business plan. After all, one of your goals is to see the customer again at lease end and offer him or her a replacement car.

The third test involves front-ending much of the overall payment, leaving a small balance spread over a longer term — not very applicable to subprime customer needs. The fourth test, that the agreed payments materially exceed the current fair rental value, could apply to LHPH; but it’s extremely subjective, so there’s wiggle room.

Skipping past the fifth test for a moment, the sixth test looks at whether the lease specifically designates part of the payment as interest. But Regulation M doesn’t require interest to be separately stated.

So the most relevant test to a LHPH situation is the aforementioned fifth test, which deals with residuals. If the residuals are too low, the deal can be recharacterized as a conditional sales contract should the IRS determine that “the property may be acquired under a purchase option at a price which is nominal in relation to the value of the property at the time when the option may be exercised, as determined at the time of entering into the original agreement, or which is a relatively small amount when compared with the total payments which are required to be made.”

Did you follow that? Hang on, there’s more. The IRS ruling also stated: “In the absence of compelling factors indicating a different intent, it will be presumed that a conditional sales contract was intended if the total of the rental payments and any option price payable in addition thereto approximates the price at which the equipment could have been acquired by purchase at the time of entering into the agreement.”

This can be equally troublesome for LHPH operations. In conjunction with the residual test above, with leases using residuals running 5 to 8 percent of the original base cap cost at inception, 92 to 95 percent of what the customer could have bought the car for at inception has been paid by lease end. So, after three or four years, an $11,000 car may have an assigned residual of as little as $600. That’s a bargain, and any LHPH company writing similarly calculated leases has real issues to consider.   

Citing Precedent

In 1972, the U.S. Tax Court decided a major case favoring a leasing company over the IRS. The court gave great weight to the residual percentage in its favorable decision — basically, it applied that crucial fifth test. However, as a percentage of market value at inception, the residuals ran from a low of 10 percent up to 35 percent.

If the residual is too low and, for tax purposes, becomes a disguised sale rather than a true tax lease, then the LHPH dealer forfeits any depreciation benefits. That means the tax balance sheet and income statement must be recalculated to book the sale, eliminate lease payments as income and treat only the interest component of the reclassified loan payments as interest income that year — and possibly for contracts in other years.

See, what makes this business model profitable is the ability to utilize implicit rates above state usury caps in the LHPH calculation since Regulation M doesn’t require its disclosure. That benefit, however, is a double-edged sword. Why not raise that residual and offset the resulting downward adjustment in the payment calculation with a slightly higher implicit rate and play it safe with the IRS? In golf terms, it’s like “laying up” in front of the water hazard rather than going for the green and risking a penalty drop. (Think Kevin Costner in “Tin Cup.”)

As an owner, you need to be on top of the lease details. Check your residual percentage by dividing the residual used by the cap cost. In the event of an IRS-determined balance owed due to lease reclassifications, that could easily cost you as the owner — including the penalties and interest — 40 percent of the additional income the IRS added back for each of those years.

Nathan King is a certified public accountant with He offers accounting and tax consulting as well as early lease termination protection packages to LHPH dealers. [email protected]