Editor: Annette B. Smith, CPA
FASB in 2016 issued Accounting Standards Update No. 2016-02, Leases (Topic 842), which is effective for public companies for fiscal years and interim periods within fiscal years beginning after Dec. 15, 2018 (Dec. 15, 2021, for entities not meeting FASB's definition of a public business entity).
FASB Accounting Standards Codification Topic 842, Leases, significantly affects financial statement accounting for lessees, eliminating the traditional concept of an operating lease and requiring virtually all leases to be presented on the balance sheet. Topic 842 should not significantly affect the financial accounting for lessors, although some lessors may conclude, while considering the impact of Topic 842, that they were improperly accounting for leases.
Topic 842 does not affect how leases are treated for federal income tax purposes. Thus, differences in the treatment of leases for financial accounting and income tax accounting remain, and implementing Topic 842 may highlight improper historical tax accounting methods.
New financial accounting model for lessees and lessors
Before the issuance of Topic 842, lessees disclosed operating leases in the footnotes of financial statements. Topic 842 requires lessees to recognize a right-of-use asset and a lease liability on the balance sheet for virtually all leases (other than short-term leases). The liability is equal to the present value of future lease payments. The right-of-use asset is based on the liability, subject to adjustment (such as for initial direct costs).
For income statement purposes, Topic 842 retains a dual model, requiring leases to be classified as either operating or finance. Operating leases result in straight-line expense, and finance leases result in a front-loaded expense pattern.
Lessors continue to classify leases as operating, direct financing, or sales-type under Topic 842.
Tax accounting for leases
In the course of adopting Topic 842, taxpayers should review their income tax accounting methods for leasing-related items, including lease characterization (i.e., sale, lease, or financing), timing of rental income or expense under Sec. 467, treatment of tenant improvement allowances, and treatment of lease acquisition costs. A tax accounting method change may provide more appropriate or beneficial tax treatment.
Lease characterization: Generally, the tax characterization of a lease does not follow its book characterization. Accordingly, taxpayers should continue to perform a separate lease characterization analysis for tax purposes.
Many taxpayers apply bright-line standards to determine lease classification for book purposes. In contrast, for tax purposes leases are characterized based on all the facts and circumstances existing at the time an agreement is executed. Whether a leasing transaction is a true lease — rather than, for example, a sale/financing arrangement — is determined by whether sufficient benefits and burdens of ownership have passed to the purchaser/lessee.
In a sale/financing arrangement, the lessee is the tax owner of the leased property and depreciates the property under Secs. 167 and 168. Payments under the lease agreement are treated as the repayment of a loan. The lessor is treated as selling the property and recognizes gain equal to the present value of the lease payments less its basis in the leased property and recognizes interest income over the payment term. In a true lease, the lessee does not have an ownership interest in the leased property and treats payments over the lease term as rent expense. The lessor is treated as owning the property and recognizes depreciation expense and rental income over the lease term.
Leases subject to Sec. 467: Sec. 467 generally applies to lessors and lessees when (1) rental agreements are for the use of tangible property; (2) total rent under the agreement exceeds $250,000; and (3) the rental agreement provides for increasing or decreasing rent, or prepaid or deferred rent, subject to limited exceptions (such as a three-month rent holiday at the beginning of a lease term).
Sec. 467 requires lessors and lessees to account for rental income and expense under one of three methods: constant rental accrual, proportional rental accrual, or Sec. 467 rental agreement accrual. Most Sec. 467 rental agreements are subject to the Sec. 467 rental agreement accrual method, which results in rental income or expense when rent payments are due and payable under the agreement. Thus, rental income and expense are almost never reported on a straight-line basis as they are for book purposes.
Tenant improvement allowances: For book purposes, lessor payments to the lessee for leasehold or tenant improvement allowances reduce the consideration in the contract, effectively decreasing the right-of-use asset. The leasehold or tenant improvement allowance is recognized straight-line over the period that the right-of-use asset is amortized.
In contrast, the most important factor in determining the appropriate federal income tax treatment of a tenant improvement allowance generally is the tax ownership of the resulting leasehold improvements, determined under a benefits-and-burdens-of-ownership analysis.
When a lessor that provides a tenant improvement allowance to a lessee owns the resulting leasehold improvements, the lessee generally does not recognize the allowance as income or have a depreciable interest in the improvements. The lessor may depreciate the assets under Secs. 167 and 168. When the lessee owns the resulting leasehold improvements, the lessee generally recognizes income and has a depreciable interest in the improvements. The lessor generally capitalizes the tenant improvement allowance and amortizes it over the term of the lease.
Sec. 110 provides a limited exclusion from a lessee's gross income for a lessor's payment of a "qualified lessee construction allowance." A qualified lessee construction allowance must relate to a short-term lease of retail space and be used to construct or improve qualified long-term real property used in the retail space.
Lessees following book for tenant improvement allowances may be incorrectly reporting income and expenses from the allowance or may be overstating taxable income.
Lease acquisition costs: Both book and tax require the capitalization of lease acquisition costs. However, Regs. Sec. 1.263(a)-4 provides that certain internal costs (e.g., employee compensation and overhead) and de minimis costs are not required to be capitalized for tax purposes. Accordingly, taxpayers following book treatment may be overcapitalizing costs.
Accounting method changes
Companies that have mischaracterized a lease for income tax purposes may change their methods of accounting using the automatic procedures in Rev. Proc. 2019-43. The change is made with a Sec. 481(a) adjustment and is eligible for audit protection. Taxpayers generally also may make automatic accounting method changes for tenant improvement allowances, Sec. 467 rental agreements, and lease acquisition costs with a Sec. 481(a) adjustment and audit protection.
When adopting Topic 842, taxpayers should be aware that the standard does not change income tax accounting treatment for leases. Accordingly, financial accounting and tax accounting treatment may differ.
Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.