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By William Bronchick, Esq.

The sale/leaseback is a financing technique that has been used in the United States since the 1940's. Sale/leaseback transactions provide alternative methods of ownership, investment, financing and risk allocation.

The transaction, in its most basic form, involves the sale of a property to an investor who holds title and leases the property back to the former owner. The lease is typically a long-term "net" lease, with the seller/tenant having the option of repurchasing at a later time. The seller/tenant reaps the benefit of favorable 100% "financing" and still retains the use of the property. The buyer/landlord receives the tax benefit of depreciation and a guaranteed long-term rental. A sale/leaseback, however, can turn into a disaster if the seller/tenant files bankruptcy or either party is audited by the IRS. In either case, the transaction can be recharacterized by the Court as a "disguised" financing transaction. This article will attempt to suggest some guidelines for avoiding this recharacterization.

Recharacterization in the Context of Seller/Tenant's Insolvency

If the seller/tenant is unable to make payments on the lease, the buyer/landlord may try to evict the seller/tenant and extinguish his interest. In this case, the seller/tenant can file for protection under the Federal Bankruptcy laws. His attorney will argue that the sale/leaseback should be recharacterized as a financing transaction. If the Bankruptcy Court agrees, the buyer/landlord will be considered a mortgagee, and title will revert back to the seller/tenant. The recharacterization, while beneficial to the seller/tenant, will result in unintended, and often disastrous consequences to the buyer/landlord.

The Bankruptcy Court will look to the intent of the parties to the transaction, rather than the actual paperwork, in determining whether the sale/leaseback was intended to be a financing arrangement. The key factors are:

1) Whether the seller/tenant originally sought a loan from the buyer/landlord;

2) Whether the circumstances indicate a normal sale and lease arrangement (or do the circumstances indicate a lender/borrower relationship);

3) Whether the purchase price reflected the fair market value of the property (or was inflated to a price necessary to finance the transaction);

4) Whether the lease reflected the fair market value of the property (or was based on the amortization and intended rate of return on buyer/landlord's investment);

5) Whether the option to repurchase was set so far below market value as to effectively compel the seller/tenant to exercise;

The court will balance all of these factors and take a "substance over form" approach.

Recharacterization for Tax Purposes

If either party to a sale/leaseback is audited, the IRS can recharacterize the sale/leaseback as a financing arrangement. This will result in an immediate recapture of buyer/landlord's depreciation of the property and imputed interest on the seller/tenant's rental payments. The seller/tenant will lose the deduction for his rental payments, since the payments will be reclassified and principal repayment of a loan.

The guidelines for IRS recharacterization are not as clear as those for Bankruptcy recharacterizations, and it is clearly a case-by-case analysis. The United States Supreme Court, in the landmark case of Frank Lyon Co. v. United States, stated the following factors to be considered for recharacterization:

1) The "economic substance" of the transaction based upon the potential risks and gains of the parties, and

2) Whether there was a purpose other than tax avoidance for the transaction.

Guidelines for Structuring the Transaction

While the above standards set forth by the courts are not crystal clear, there are a few guidelines that we can follow to avoid recharacterization by the IRS or a Bankruptcy Court:

1) Make certain that the purchase price of the property is for fair market value;

2) Make certain the lease payments are for fair market rent, and that the lease arrangement is typical of the area and the intended use;

3) Have reasons (other than tax avoidance) for the transaction and state those reasons in the preamble of your agreement;

4) If seller/tenant has an option to repurchase, make certain that it is based upon fair market value and not on a declining basis with unusually large rent credits (i.e., make sure it doesn't look like a loan payoff);

5) Make certain that the buyer/landlord has the rights of any typical landlord in a comparable lease arrangement (including the right to have the property back at the end of the lease!);

6) Make certain that there is nothing in the sale/leaseback arrangement that prevents the buyer/landlord from selling, mortgaging or assigning his interest or from benefitting from the appreciation of the property.

There is no real way to guarantee that a Court or IRS auditor will agree with your characterization of a transaction as a sale/leaseback. Use your best judgment, follow the guidelines set forth by the courts and remember . . . if it looks like a duck, and it quacks like a duck - well, you know the rest!