The Fourth Circuit Court of Appeals held that a
LILO (lease in, lease out) transaction by banking
company BB&T Corp. was not a genuine leasehold
interest but only a circular transfer of funds. In so
ruling, the Fourth Circuit upheld a district court’s
denial of deductions arising from the deal. At
the recommendation of a LILO promoter, BB&T in
1997 leased an interest in wood pulp manufacturing
equipment from a Swedish cooperative for 36 years. The
bank simultaneously leased the equipment back to the
cooperative for 15.5 years. At the end of the
sublease, the cooperative could repurchase the
remaining lease years. Alternatively, BB&T could
extend its lease for another 13.3 years or lease the
equipment to another party. In effect, the cooperative
continued to use the equipment and had significant
incentives to reacquire all rights at the end of the
sublease. The deal was partially financed by a loan
secured and repaid by the rent payments, resulting in
a $68 million intrabank transfer in which no money
changed hands. On its 1997 tax return, BB&T
reported a deduction for rent, interest and fees, net
of sublease income, of $9.4 million, which the IRS
disallowed. LILOs, like other tax shelter
transactions, are usually evaluated under the economic
substance doctrine. Since the litigation was for
summary judgment, the court decided to analyze the
lease and loan separately, using the
form-versus-substance doctrine instead of the economic
substance doctrine. The analysis of the lease
was based on the Supreme Court’s decision in Frank
Lyon Co . (41 AFTR2d 78-1142) that a lease will
be honored if the lessor retains significant and
genuine attributes of the traditional lessor status.
In the actual transaction, the court found that all
rights given to BB&T were returned to the
cooperative. The bottom line was that BB&T had
solely an annual inspection right. An analysis of the
cash flow showed that the only real transfer was $6
million from BB&T to the cooperative to
participate. The cooperative continued to use the
equipment without any interruption, and the deal
protected BB&T from losing the other $12 million
it put up. The end result bore no resemblance to a
traditional lease, the court said. Therefore, the form
was not respected. Next, the court analyzed
the loan interest deduction. Since the funds never
actually left the bank, which treated the deal as an
off-balance-sheet transaction, no money was actually
loaned, the court said, and no interest deduction
permitted. The opinion quoted a riddle
attributed to Abraham Lincoln: How many legs does a
dog have if its tail is called a leg? The answer is
four, since calling a tail a leg does not make it one.
Calling a transaction a lease or a loan does not make
it one if the rights and obligations do not match the
title, the court said. Taxpayers should not forget
that the form-versus-substance and step transaction
doctrines will prevent tax abuse even if the plan is
carefully structured to avoid being disallowed under
the economic substance doctrine.
BB&T Corp. v. U.S. , 101
AFTR2d 2008-1933
By Edward J. Schnee , CPA, Ph.D.,
Hugh Culverhouse Professor of Accountancy and
director, MTA program, Culverhouse School of
Accountancy, University of Alabama, Tuscaloosa.
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