Leasing equipment to avoid AMT.

There are tax advantages to sale/leasebacks: Corporations with large investments in property, plant and equipment generally have significant annual depreciation deductions. With the accelerated write-offs allowed under the tax laws, these deductions often exceed the amount on the corporation's balance sheet, resulting in deferred tax liability.

If the corporation continues its capital expenditures, it can defer paying that liability almost indefinitely, creating a form of tax shelter for the corporation. The alternative minimum tax (AMT), however, limits a corporation's ability to reduce its current tax burden through depreciation.

ACEd out by the AMT

The AMT creates headaches for many taxpayers. The recent application of the adjusted current earnings (ACE) provisions to AMT computations exacerbates the situation by causing bizarre results for capital-intensive corporations.

The ACE/AMT rules require corporations to recompute depreciation using longer lives and slower methods. For example, the regular tax depreciation deduction for $100,000 of transportation equipment placed in service in 1991 is $20,000. The AMT depreciation equivalent for the same equipment is $12,500. But under ACE, the allowable deduction is only $8,333.

It is easy to see how these differences can turn what would have been a taxable loss under the regular tax into a taxable gain under AMT - and a tax liability for the taxpayer.

Corporate taxpayers can avoid these surprises through a sale/leaseback. Trading off depreciation deductions for rent expense eliminates the AMT and ACE adjustments; the loss is a loss and no tax is payable. Thus, AMT planning adds a new dimension to sale/leaseback transactions.

Sale/leasebacks have their own special tax considerations. The transaction must be a true sale/leaseback and not a disguised financing arrangement. Tax treatment also differs depending on the classification of the lease (see the chart above).

An IRS-eye view

To be a true sale/leaseback, the transaction generally must have two characteristics. First, the transaction must have a business purpose other than gaining tax benefits. Second, the lessor must have a reasonable chance at realizing a profit. This is often referred to as "economic substance."

The transaction must be well documented. If the transaction meets these criteria, lease payments generally are fully deductible.

If the IRS recharacterizes the transaction as a financing arrangement, the taxpayer will be allowed to deduct lease payments only to the extent they constitute interest. The noninterest portion will be considered a principal payment and would be deductible only through depreciation, since the taxpayer would be deemed to have maintained ownership of the asset for tax purposes. Thus, the ACE/AMT rules would continue to apply.

Here are a few steps that can be taken to keep the Service from recharacterizing the transaction as a financing arrangement. * Set the purchase price at fair market value (FMV) and document the price with an appraisal. * Have the buyer-lessor make an equity investment in the asset acquired. * Base lease payments on FMV, not the lessor's costs. * Do not set the lease term for the economic life of the property. * Do not retain a repurchase option. * Make sure the buyer-lessor bears the risks and rewards of ownership. * Document a business purpose for the transaction. * Treat the transaction as a sale/leaseback and observe all formalities of such transactions. * Make the terms of the lease independent of the terms of the buyer-lessor's financing.

Tax considerations should never be the driving force behind a transaction. In most cases, the primary benefits of a sale/leaseback are improving the corporate balance sheet and increasing working capital.

However, taxpayers should keep the limited benefit for depreciation under the AMT/ACE rules in mind when considering sale/leasebacks.

Tax Treatment of Sale/Leasebacks
                                              Financing
                        Sales/leaseback      arrangement
Gain/loss on "sale"   Generally gain/loss    N/A
  of asset            recognized
Lease payments        Generally fully        Deductible
                      deductible             only to the
                                             extent rent is
                                             recharacterized
                                             as "interest"
Depreciation          N/A                    Fully
                                             depreciable
Tax preference        N/A                    Adjustment for
                                             ACE and AMT
                                             depreciation