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Tax Considerations in Light of New Lease Standards

Over five years after its original issuance, the new accounting lease standard (ASC 842) will become effective for all private companies for fiscal years beginning after December 15, 2021.  While we have discussed the financial statement impact of ASC 842 in previous editions of TBC Today, companies should also consider the potential impact on their future tax filings.

As a reminder, prior to ASC 842, operating lease payments were treated as expenses over the life of the lease and were disclosed in the footnotes of the financial statements.  Under the new standard, lessees will now be required to report a liability for the present value of future lease payments and a corresponding “right-of-use” asset on their financial statement balance sheet.  The lease payments related to these operating leases will be expensed on a straight-line basis for financial statement purposes.

Despite the significant changes to lease reporting for financial statement purposes, ASC 842 does not make any changes to the treatment of leases for income tax purposes.  As in the past, the characterization of a lease for tax purposes may differ from the characterization required for financial statement purposes.  For example, based on the facts and circumstances an arrangement treated as a lease for financial statement purposes may be treated as a sale for tax purposes if sufficient ownership and/or control has transferred to the lessee.  As a result, the taxpayer would depreciate the asset as if they owned it for tax purposes but would continue to deduct the lease payments over the life of the lease for financial purposes.  As businesses take a close look at their leases in light of ASC 842, it may be prudent to evaluate how these leases have been treated for tax purposes; if using an improper tax method it may be appropriate for the business to consider making an accounting method change on their next tax return.

Due to the potential for different characterization of leases for financial and tax purposes, taxpayers entering into lease transactions should be aware that may need to make certain adjustments to financial statement income to arrive at taxable income.  Further, taxpayers operating as C Corporations will need to consider the impact of these differences when computing their deferred tax assets and liabilities.

Due to the many complexities of ASC 842 and the potential impact on both financial statement and tax reporting, we encourage businesses that are party to lease transactions to consult their trusted TBC advisor to discuss the new standard in more detail.