If you are a business owner, you may already know of recent changes to the Generally Accepted Accounting Principles (“GAAP”) applicable to leases of personal property.[1] The rule changes were originally to be effective for all businesses at the end of 2019, but currently only public companies must follow the new standards, with all other businesses set to follow no later than December 2020.

What are the changes, and why do they matter?

Under the new GAAP rules, all leases more than one year in length are treated as assets on the lessee’s balance sheet, and not as expenses on the lessee’s income statement.[2] Under the prior rules, “capital leases” were treated as assets of the lessee, while operating leases were treated as expenses of the lessee. The new rules, which will apply prospectively to new leases entered after the rules take effect and to leases already on the books, will have the effect of moving most leases to the lessee’s balance sheet. As a result, prudent lessees will need to decide whether to structure their new leases as “finance leases”[3] or “operating leases,” depending on the accounting-related advantages they wish to capture.[4]  In so deciding, lessees should consider the legal rights and responsibilities associated with each structure.

Why should a lease ever be treated as an asset of the lessee?

While some leases are true “leases,” other leases are more properly characterized as disguised sales of personal property from the lessor to the lessee. For various legitimate business reasons (e.g., tax treatment, accounting, and bankruptcy, among others)[5] it may be advantageous for a seller and buyer of personal property to structure a transaction as a lease, when they really intend a sale.

Legally speaking, why is the distinction important?

Whether the transaction is a true lease or a disguised sale will impact not just the rights and remedies available to the lessee and lessor, but also the rights of the lessee’s creditors.[6] If the transaction is deemed a true lease, the lessee does not have title to the goods, only the right to possession, which has relatively little value to the lessee’s creditors.  If, however, the lease is a disguised sale, the lessee’s creditors could potentially perfect a security interest in the “leased” property, to the detriment of the lessor.  Additionally, while the lessor has the right to repossess the property upon default in either case,[7] if the lease is deemed a secured transaction, the lessor must dispose of the collateral in strict accordance with Article 9 of the Uniform Commercial Code (“UCC”).[8]  The potential concerns reach beyond the provisions of the UCC. For example, in an Indiana tax case, an entity that believed it had created sales with security interests in its contracts was penalized by the state for not including the property in its personal property tax return after the court determined the contracts were actually true leases.[9] This issue also comes up with frequency in bankruptcy courts because leases and security agreements are treated differently in the Bankruptcy Code.[10]

How do courts distinguish a true lease from a disguised sale?

Courts look to the economic realities of the transaction, and not the labels used by the parties, to determine whether a transaction is a true lease or a disguised sale.[11] Accordingly, even if your contract says “Lease Agreement” at the top and the word “lease” is on every page, it might still be a sale as a matter of law if the economic realities of the transaction show that it is a sale.

Nearly all states (including Indiana) have adopted Article 2A of the UCC, which applies to any transaction, regardless of form, that creates a lease, which is defined as the transfer of the right to possession and use of a good for a set period of time and for consideration, excluding sales and the retention or creation of security interests.[12] By contrast, Article 9 of the UCC governs any transaction, regardless of form, that creates a security interest, which is simply “an interest in personal property or fixtures which secures payment or performance of an obligation.”[13] The principal difference is that in a lease, the lessor retains title and will receive the goods back after the lease term, whereas in a sale with a security interest, the buyer receives title but the seller has the right to repossess the property on default. Though this seems like a bright line, in practice the distinction often becomes blurred due to the similarities of the structures of both types of transactions.

In determining whether a transaction is a lease versus a disguised sale, “all the economic factors which drove the transaction, and which were the prime impetus to the ultimate decision to enter into the transaction and the reasons for structuring the transaction as it was done” are relevant considerations.[14] Under the UCC as adopted in Indiana, a transaction is a disguised sale, not a lease, if the lessee does not have a right to terminate the lease before the end of the lease term and any of the following conditions are present:

1. At the end of the lease term, there is almost no usable economic life remaining in the goods;
2. At the end of the lease term, the lease requires the lessee to renew the lease for the remaining economic life of the goods or requires the lessee to become the owner of the goods;
3. After the initial lease term, the lessee has an option to renew the lease for the remaining economic life of the goods for no or “nominal” consideration; or
4. After the initial lease term, the lessee has an option to become owner of the goods for either no additional consideration, or consideration that is less than the fair market value of the goods at the time the option is exercised.”[15]

For example, if the lessee of a $100,000.00 piece of equipment has to perform the lease in full, has no right to terminate early, and has an option to buy the property for $1.00 at the end of the lease term, it is likely a sale.

Other factors Indiana courts consider in determining the economic realities of a lease transaction:

1. Practical limitations on the lessee’s ability to remove and return leased goods;
2. The ability of the lessor to market the equipment when the term expires;
3. The presence of a balloon payment; and
4. Situations where the cost of returning the collateral exceeds the purchase price under an option to buy provision.[16]

Why does the change in GAAP matter?

Under the new GAAP rules businesses will no longer have the option to treat a long-term lease as an expense and must choose between two classes of capitalized leases. Therefore, the new rules may incentivize an otherwise indifferent lessee to structure new leases as finance leases in certain circumstances, such as when capturing depreciation is a priority for accounting or tax purposes. The factors used by GAAP to classify a finance lease are as follows:

1. Whether the lease transfers the underlying asset to the lessee when the lease term concludes;
2. Whether the lease grants the lessee an option to purchase the asset that the lessee is reasonably certain to exercise;
3. Whether the lease term is for most of the asset’s remaining economic life;
4. Whether the present value of the sum of lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all the fair value of the asset; and
5. Whether the asset is of a specialized nature such that the lessor would not have any alternative use for the asset at the end of the lease term.[17]

These factors are substantially similar to the factors that courts use to distinguish true leases from disguised sales. As lessees negotiate new leases with an eye toward structuring them as finance leases on the advice of an accountant or tax professional, lessees (and lessors) should be aware that courts may treat such leases as disguised sales, regardless of the label the parties place on the transaction.

[1] The rule changes also apply to real property, but this article is focused on personal property (such as vehicles and equipment).

[2] Financial Accounting Standards Board, Accounting Standards Update, Leases (Topic 842), No. 2016-02 (February 2016), p. 2-3 (available at https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901010&acceptedDisclaimer=true) (hereinafter “FASB”).

[3] To add to confusion, the Uniform Commercial Code also uses the term “finance lease,” but its meaning is entirely different than the GAAP definition.

[4] See FASB, p. 3.

[5] See e.g., Ind. Code § 26-1-1-201 cmt. 37.

[6] Id.

[7] I.C. § 26-1-2.1-525; I.C. § 26-1-9.1-609

[8] Compare I.C. § 26-1-9.1-610 with I.C. § 26-1-2.1-103(1)(q).

[9] W.H. Paige & Co. v. State Board of Tax Commissioners, 732 N.E.2d 269, 272 (Ind. Tax Ct. 2000).

[10] See e.g., In re Wordlcom, Inc., 339 B.R. 56, 63 (Bankr. S.D.N.Y. 2006).

[11] Gibraltar Financial Corp. v. Prestige Equipment Corp., 949 N.E.2d 314, 318 (Ind. 2011); I.C. § 26-1-1-201 cmt. 37.

[12] I.C. § 26-1-2.1-103(1)(j).

[13] I.C. § 26-1-1-201(37).

[14] Gibraltar, 949 N.E.2d at 324 (citing Am. President Lines, Ltd. v. Lykes Bros. Steamship Co., Inc. (In re Lykes Bros. Steamship Co., Inc.), 196 B.R. 574, 580 (Bankr.M.D.Fla.1996)).

[15] I.C. § 26-1-1-201(37)

[16] Gibraltar, 949 N.E.2d at 323

[17]  FASB, p. 30. Finance leases essentially take the place of Capital Leases as defined in previous GAAP, though the factors that determine finance leases are slightly different from those that determined capital lease classification. Id. at 2, 88.

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Posted on January, 27 2020  by Patrick S. McCarney