Q.What is an IRS Reclassification?
A.Occasionally, the IRS will reclassify an equipment lease as a disguised sale. This may occur where the lessee makes rental payments for a number of years then has the option to buy at the end of the term for a nominal amount, such as $1.
The IRS looks at the terms of the lease and the circumstances surrounding the lease to determine whether a sale was intended. The following are some things that will tend toward a sale, rather than a lease:
- if the lessee is paying the taxes and insurance on the equipment.
- if a substantial part of the payments on the lease are credited towards the future purchase of the equipment.
- if the purchase option price declines each year, rather than increases with the fair market value.
Most of the reported cases where the IRS has reclassified a lease as a disguised sale involve long-term leases. Thus, an equipment lease for only a few years is not likely to be re-characterized as a disguised sale.
If the IRS does recharacterize your lease as a sale, your rental payments will not be deductible. Instead, you will be entitled to depreciation deductions as the owner of the property for tax purposes. In addition, a portion of your rental payments, which the IRS effectively recharacterizes as being installment payments on a purchase price, will likely be considered interest that you can currently deduct.
We strongly suggest that you discuss the possible tax implications of your equipment lease with an accountant before signing any contract.