On Feb. 25, 2016, new guidance was issued by the Financial Accounting Standards Board (FASB) for an Accounting Standards Update on topic 842 for leases. The guidance was created to allow transparency for investors and financial statement users to assess the timing, amount, and cash flow from leases as well as provide fewer opportunities for structuring leasing transactions to create specific outcomes on the balance sheet. Under the new standard, for most leases, a lessee will recognize a lease liability and a related asset on the balance sheet.
For public companies and certain other entities the new guidance will be effective for fiscal years (and interim periods within those fiscal years) beginning after Dec. 15, 2018. For a calendar-year company, the guidance is effective Jan. 1, 2019. For all other organizations, the guidance is effective for fiscal years beginning after Dec. 15, 2021 and for interim periods within fiscal years beginning after Dec. 15, 2022. However, companies are permitted to adopt the standard early.
Under ASC 842, a lessor classifies leases for general accepted accounting principles (GAAP) as either a sales-type, direct financing or operating lease. For federal tax purposes, leases are treated as either a true lease, sale of asset(s), or a financing transaction.
Under the old guidance (ASC 840), operating leases were not recorded on the balance sheet, but under ASC 842 operating leases are required to be recorded on the balance sheet, which results in the addition of more assets and liabilities on the balance sheet. Finance (capital) leases will continue to be recognized on the balance sheet. Certain types of assets are excluded from the new standard–leases relating to inventory, intangibles, and some natural resources. The recognition, measurement, and presentation of expenses and cash flows from a lease will continue to depend on its classification as a finance or operating lease. The classification criteria in ASC 842 does not impact the classification for most leases, however, the bright-line classification of ASC 840 was replaced with a principles-based approach.
Under GAAP, lessees are required to book a right-of-use asset and related lease liability for all leases, operating or finance (under ASC 840) that are not considered short-term leases. For tax purposes, an operating lease will be treated as a true lease, with the lessor maintaining ownership of the asset and depreciation deductions, while the lessee has deductions related to rental payments. A finance lease (capital lease under ASC 840) gives the tax benefits, such as depreciation deductions and deductions for interest payments, to the lessee. The lessor would recognize interest income in this situation.
Due to these changes, new deferred tax assets and liabilities or adjustments to existing deferred tax assets and liabilities will impact financial statements. In the new guidance review process, lessors and lessees may discover that certain existing leases/sales/financing transactions may be misclassified for GAAP and/or federal income tax purposes and may require an accounting method change to correct existing leases/sales/financing transactions or change their tax treatment on a prospective basis.
Federal income tax implications
Under federal tax principles, whether an agreement, in the form of a lease, is in substance a conditional sales contract depends upon the intent of the parties as evidenced by the provisions of the agreement, read in the light of the facts and circumstances existing at the time the agreement was executed. In ascertaining such intent no single test, or any special combination of tests, is absolutely determinative. No general rule, applicable to all cases, can be laid down. Each case must be decided in the light of its particular facts, evaluating the benefits and burdens of ownership and whether these transfer between the parties. While the majority of operating leases are true leases, that is not true in every circumstance. It is possible for lease treatment on the financial statements to differ from treatment for federal income tax purposes.
Under section 446, a taxpayer who changes the method of accounting on the basis of which it regularly computes its income in keeping his books shall, before computing its taxable income under the new method, secure the consent of the Secretary. This means that if a taxpayer changes the treatment of an item that only impacts timing, it is a method of accounting. If there is an item have consistently treated properly once on a return or twice if the treatment is improper then you need the Secretary’s consent before a taxpayer can change the treatment of that item.
In order to change an accounting method for leases/sales/financing transactions, taxpayers would need to file an automatic method change under section 6.03 of Revenue Procedure 2019-43 (or successor). The accounting method change under Revenue Procedure 2019-43 allows reclassification of leases (existing and new) with a section 481(a) adjustment. In order to make this change, taxpayers must file the Form 3115 with the IRS in in Ogden, UT, and attach a copy of the Form 3115 to a timely filed return (including extensions).There is no IRS user fee associated with a method change under the automatic procedures.
Under the new ASC 842 standard, taxpayers may have to begin capitalizing certain transaction costs (third-party commissions, internal commissions, etc.) to the lease and recovering them through amortization. While section 1.263(a)-4 requires capitalization of external transaction costs, taxpayers can either capitalize or expense internal transaction costs that relate to employee compensation or overhead. Taxpayers will need to decide on whether to follow their financial statements and capitalize internal transaction costs or accelerate the recovery of those costs and have a book/tax Difference. To the extent that taxpayers are not capitalizing these transaction costs and want to begin capitalizing these transaction costs, taxpayers will need to file a Form 3115 to begin capitalizing the external transactions costs. Generally, the IRS permits these applications for change in accounting method to use the automatic consent provisions with a historic adjustment (section 481(a) adjustment).