If a lease fails the burden-of-proof test, how is the lessor's tax treatment generally characterized?

• A. It remains a lease with rent recognized over the term.
• B. It is treated as a sale; rental income to the extent the total lease payments exceed the equipment cost; interest amortized over the life.
• C. It is ignored for tax.
• D. It results in immediate deduction of the equipment cost.

Answer: (B)

When a lease fails the burden-of-proof test, the tax treatment switches from a true lease to sale-type accounting for the transaction. That means the lessor is considered to have sold the equipment rather than merely renting it. The payments received are then allocated between recovering the asset’s cost and earning interest. Specifically, the portion of the total lease payments that exceeds the cost of the equipment is treated as interest income earned over the life of the lease, while the amount up to the equipment’s cost is treated as a return of the capital invested (i.e., the sale-related portion). This aligns with the idea that the arrangement is a sale-for-tax purposes, not a standard rental.