Equipment Leasing Programs

Tax Issue

Taxpayers often have the desire to have investments earn high current income while paying little or no income tax on that income. This is especially true for taxpayers with higher income. These investors are also looking to diversify assets to reduce risk.

Applicable Tax Law

• Equipment leasing programs are usually set up as limited partnerships. Investors have limited liability and the general partner manages the investment.
• As a limited partnership, income and losses flow through to the individual investor. Because the investor does not materially participate in the partnership, the deductions of losses of the partnership are limited to the income of passive activities.
• Investors gain several advantages by investing in equipment leasing programs.

– Diversification of investment assets.

– Regular income through cash distributions.

– Investing in tangible assets that are protected through collateralization.

– Potential hedge against inflation.

– Investing in assets that are not directly correlated to the stock or bond markets.

• Equipment leasing programs are set up in three stages:

1. Offering period. During this time, the program seeks out investors and accumulates cash. Distributions may begin being paid out to the investors, but the distributions come from capital paid in and not from operations. This period is usually about two years.
2. Operation period. Purchased equipment is leased out to businesses. This period is usually five to seven years.
3. Liquidation period. Equipment is sold off. Any residual benefit is paid to the investor or reinvested in a new program. This period usually lasts up to two years.

• Much of the equipment leased out by equipment leasing programs is depreciated rather quickly and the depreciating is passed through to the investor, creating tax-favored income for the investor.
• Leases to companies are generally net leases. In addition to paying the lease, the company leasing the equipment from the equipment leasing program will generally pay the costs to repair and maintain the equipment. Common types of equipment that are leased include:

– Rail cars.

– Marine vessels and equipment.

– Mining and manufacturing equipment.

– Computers and telecommunications equipment.

Tax Planning Strategies

Taxpayers seeking steady cash flow may want to consider investing in an equipment leasing program. Equipment leasing programs offer investors an opportunity to invest in tangible items that are used by businesses on a daily basis. Often, these businesses do not want to purchase equipment outright, either because they do not have sufficient funds to make the purchase or because the companies do not want to tie up money in the assets.

Tax-favored income. Tax-favored distributions can provide an investor with income while minimizing tax on that income. Investors buy units of an equipment leasing programs. The partnership uses the proceeds from the investors to purchase equipment that is then leased to businesses for use. The company leasing the equipment pays regular lease payments to the leasing partnership’s general partner. The general partner then pays income to the investor and also passes along the depreciation of the equipment.

Liquidation. The terms of the lease will state that the lease will end at a specified date. The leasing partner will collect and sell off all the equipment. The residual value of the equipment is returned to the investor. Often, terms of the lease will allow the company leasing the equipment to buy the equipment at a predetermined price.

Examples

Example: Henry invests $50,000 in Capital Fund, and limited partnership established for the purposes of leasing rail cars to railroad companies. Capital Fund offers a 10% payout to investors. Henry receives $5,000 for each of the first two years of the investment. These payouts represent a return of capital and are not taxable. By year three, Capital Fund has leased out property, is earning income, and is passing income, along with depreciation and other expenses, on to the investors. Henry receives the following:

During the eighth year, Capital Fund liquidates assets and send the proceeds to the investors, closing the fund. Henry receives a check for $30,000, representing the residual value of equipment. Henry has a capital gain of $15,000 ($30,000 residual value minus $15,000 basis). The suspended losses are allowed as a deduction in the year the passive activity is disposed of.

Over the period of seven-plus years, Henry received a total of $65,000 in distributions. The annual distributions were tax-favored either in the form of return of capital or because of distributions of cash flow from operations. The gain is taxed as a capital gain instead of ordinary income.

Possible Risks

• The distributions an investor receives may be in the form of return of capital rather than income. The rate of these distributions does not always represent a rate of return on capital. For example, a $10,000 investment that generates $800 annual distributions does not necessarily represent an 8% return on the investment because some or all of the $800 distribution may be a return of capital.
• External market factors can have an impact on the leasing equipment. For example, a company may lease a lot of equipment and subsequently fall on bad times when there is a change in that company’s performance or industry. The company could default on the lease and the equipment might be difficult to re-lease.
• Investments in equipment leasing are considered illiquid. There is generally no secondary market in which to sell an investor’s stake in the company.
• Investments in equipment leasing are not suitable for all investors. An investor needs to meet income and/or asset criteria to be eligible to invest in the programs. An investor generally needs $250,000 in assets or income of $70,000 or greater, along with assets of $70,000 or greater.
• The offering price for the equipment leasing program does not represent the actual value of the investment. Administrative and sales expenses are taken from the offering proceeds before money is used to buy equipment.
• The equipment leasing program often has the ability to borrow money to leverage the investment to purchase more assets. Whenever leverage exists, the potential for loss increases.
• As a limited partner, an investor may not have voting right in an equipment leasing program.
• During the early years of the investment, expenses of the program will likely be more than income.
• Equipment leasing programs generally involve a long term investment commitment. Many investors are not suitable for being invested in an illiquid investment for an extended period of time. As illustrated in the example, the benefit of equipment leasing programs isn’t truly observed until the fund liquidates. If the liquidation comes up short, the investor will have lost money and will have had the money tied-up for a long period of time.