LILO comes up one leg short.

The Fourth Circuit Court of Appeals held that a LILO (lease in, lease out) transaction by banking company BB&T Corp. was not a genuine leasehold interest but only a circular transfer of funds. In so ruling, the Fourth Circuit upheld a district court's denial of deductions arising from the deal.

At the recommendation of a LILO promoter, BB&T in 1997 leased an interest in wood pulp manufacturing equipment from a Swedish cooperative for 36 years. The bank simultaneously leased the equipment back to the cooperative for 15.5 years. At the end of the sublease, the cooperative could repurchase the remaining lease years. Alternatively, BB&T could extend its lease for another 13.3 years or lease the equipment to another party. In effect, the cooperative continued to use the equipment and had significant incentives to reacquire all rights at the end of the sublease. The deal was partially financed by a loan secured and repaid by the rent payments, resulting in a $68 million intrabank transfer in which no money changed hands. On its 1997 tax return, BB&T reported a deduction for rent, interest and fees, net of sublease income, of $9.4 million, which the IRS disallowed. LILOs, like other tax shelter transactions, are usually evaluated under the economic substance doctrine. Since the litigation was for summary judgment, the court decided to analyze the lease and loan separately, using the form-versus-substance doctrine instead of the economic substance doctrine.

The analysis of the lease was based on the Supreme Court's decision in Frank Lyon Co. (41 AFTR2d 78-1142) that a lease will be honored if the lessor retains significant and genuine attributes of the traditional lessor status. In the actual transaction, the court found that all rights to BB&T were returned to the cooperative. The bottom line was that BB&T had solely an annual inspection right. An analysis of the cash flow showed that the only real transfer was $6 million from BB&T to the cooperative to participate. The cooperative continued to use the equipment without any interruption, and the deal protected BB&T from losing the other $12 million it put up. The end result bore no resemblance to a traditional lease, the court said. Therefore, the form was not respected.

Next, the court analyzed the loan interest deduction. Since the funds never actually left the bank, which treated the deal as an off-balance-sheet transaction, no money was actually loaned, the court said, and no interest deduction permitted.

The opinion quoted a riddle attributed to Abraham Lincoln: How many legs does a dog have if its tail is called a leg? The answer is four, since calling a tail a leg does not make it one. Calling a transaction a lease or a loan does not make it one if the rights and obligations do not match the title, the court said. Taxpayers should not forget that the form-versus-substance and step transaction doctrines will prevent tax abuse even if the plan is carefully structured to avoid being disallowed under the economic substance doctrine.

BB&T Corp. v. U.S., 101 AFTR2d 2008-1933

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.