Commercial Insights

Related Party Leases

A common legal strategy is to place real estate, equipment, or other business assets in one entity, such as an LLC, and have that entity lease the assets to the company that operates the business.*

However, there are at least three situations in which the assets — and the debt incurred to acquire them — can end up on the operating company’s balance sheet, depending on how the transaction is structured:

1. Variable-interest entity

Sometimes the relationship between a leasing entity and an operating company is such that the latter can appear to be acting more like the “owner” of the entity than its legal owner is. This is evaluated by determining:

• Whether the legal owner is exhibiting “un-owner-like” characteristics (such as having less than 10% equity in the leasing entity’s assets or if the operating company has guaranteed debt of the leasing company),
• Whether the operating company has the power to direct the primary activities of the leasing entity, and
• Whether the operating company’s rights to the profits (or obligations to absorb the losses) of the leasing entity could potentially be significant to the leasing entity.

If the answer to all three determinations is yes, then the leasing entity must be included in the operating company’s balance sheet.

2. Capital leases

Under current accounting rules, a lease must be treated as a “capital lease” (and the present value of the lease payments must be included as an asset and a liability on the operating company’s balance sheet) if it meets any of the following four criteria:

• The operating company will take title to the leased assets at the end of the lease,
• The operating company has an option to buy the leased assets at the end of the lease for an amount less than their fair value,
• The lease term is more than 75% of the useful life of the assets, or
• The present value of the required lease payments is more than 90% of the fair value of the asset at the beginning of the lease.

Because the entities are related parties, the lease is not “arm’s length” and additional considerations come into play.  These are:

• A lease term that unrelated parties would agree to
• Any period for which the operating company is guaranteeing the leasing entity’s debt

3. Combined financial statements

Even in cases where neither of the two situations described above apply, current accounting rules stipulate that owners must consider whether combined financial statements — in which the balance sheets of the operating company and leasing entity have been added together — would be more useful to users of the statements. (A lender who finances activities for both entities and wishes to monitor the loans, for example, might ask for a combined financial statement.)

Get good answers — and good help

Related-party leasing can be a complex topic. To learn more, please contact Tracy Harding or your BerryDunn advisor.

* The question of whether related-party leasing provides liability protection should be discussed with legal counsel and is not the focus of this article.