By Ryan Paul, CPA
Private companies and not-for-profit entities are now required to report most leases and subleases on the balance sheet with annual reporting periods beginning after December 15, 2021. The new lease accounting changes under ASC 842 have been talked about for several years, and now, companies are making efforts to comply.
More specifically, there are challenges with how to record leases for book income under Generally Accepted Accounting Principles (GAAP) compared to the potential taxable impact of the leases. Because most lease accounting guidance has focused on GAAP compliance, the tax impact may not have been completely addressed.
Refresher on ASC 842
Under ASC 842, all leases must now be reported and included on the balance sheet. Financial executives will recall that finance leases are the new terminology for what used to be known as capital leases. Under the new guidelines, both assets and liabilities of covered leases must be recognized on the balance sheet. The goal with the change was to increase transparency and make it easier for financial statement users to understand the impact of leases on the financial health of the business and analyze future commitments.
There are a few exceptions. Leases for intangible assets, natural resource use or exploration, biological assets, including agriculture and timber, inventory, and assets under construction are not covered under ASC 842. Leases with a term of less than 12 months aren’t required to follow the same accounting rules and instead can expense on a straight line basis for the lease duration.
Within commercial real estate, ASC 842 has affected short-term leases and debt covenant issues the most. More liabilities on the balance sheet can also mean lower financial ratios. Now that companies have had opportunities to transition their accounting, other issues are arising, like how to account for leases between GAAP and tax treatments.
Tax Treatment of Leases
From a tax perspective, there are true leases and non-tax leases.
- In a true lease, the company, or lessee, deducts rental payments as they do not retain ownership of the asset.
- For tax purposes, most closely aligned with an operating lease
- In a non-tax lease, the company, or lessee, owns the asset and deducts depreciation and interest expenses.
- For tax purposes, most closely aligned with a finance lease
ASC 842 does not really change how leases are treated from a federal income tax perspective. It does, however, make accounting for leases somewhat more challenging when calculating the difference between tax and book income.
Companies will be challenged to identify and track typical book-to-tax differences as a result of making changes to journal entries made to track the lease expense. Some companies may need to create new ones to avoid misclassifying assets and liabilities.
The most common differences to be aware of relate to straight-line rents, lease characterization, and interest expenses and limitations.
Prior to ASC 842, Deferred Rent or Prepaid Rent accounts were often used to track the difference between actual cash payments and straight-line rent expenses (based on the lease). Since these accounts are gone, the assets and liabilities are measured much the same at the beginning of a lease term. Issues can arise later with deferred tax (see below) or rent impairments on finance leases due to accelerated expense recognition. It could also be possible to require a reversal of any impairments for right-of-use asset at the end of a lease term.
The key take-away here is that for income tax purposes, companies would follow the cash payment schedule for deductions but, for GAAP purposes, would follow the straight-line expensing. While these differences were accounted for in the deferred rent or prepaid rent accounts, tracking these differences provide a hefty challenge now that these accounts are no longer utilized.
IRC Section 110 allows for the exclusion of lease incentives from income to the extent they are used to construct real property improvements. Language of the lease should indicate that the landlord owns the improvements upfront and not at the end of the lease.
Absent the Section 110 exclusion, the lessee reports gross income when a lease concession is received. Under GAAP, the lease incentives are included in the right-of-use asset.
Tracking the book-to-tax differences has historically been quite easy. However, ASC 842 creates an extra challenge as now many of the lease incentives are included as part of the right-of-use asset.
There will be situations where a lessee does not capitalize a lease for income tax purposes (true/operating leases). Such companies will not have any tax basis in the right-of-use asset and lease liability under GAAP. An entity must recognize either a “deferred tax asset” or a “deferred tax liability” as a result. For example, if there is recorded GAAP basis for the right-of-use asset, then a deferred tax liability is recorded. If there is GAAP basis in the related lease liability, then a deferred tax asset would need to be recorded. For GAAP, the right-of-use asset is initially computed using the same method for both finance and operating leases. These book-to-tax differences will reverse over time and the manner of reversal will depend on whether it was a financing or operating lease. Impairments, if any, will need to be reversed for tax purposes as well.
Now that all leases are treated as finance leases for book purposes, this creates a book-to-tax difference with interest expense. The financial statements will now include interest expense on true leases (or traditional operating leases). In true leases, the book interest may need to be reversed for the income tax return.
While the federal income tax treatment of leases isn’t affected by ASC 842, other non-income taxes could be. State-based franchise taxes, sales and use taxes, and net worth taxes could be impacted since the GAAP net worth would be different.
Companies with leases that apply to international accounting standards under IFRS 16 have additional factors when computing tax liability and book value.
There are many considerations for the tax treatment of leases under ASC 842, and the facts and circumstances may differ from one lease to the next. For many companies, transitioning to lease management software may be necessary.