Questions:
Was the lease a capital lease (conditional purchase in tax terms) or a true operating lease for tax purposes? As noted above, justify your answer.
Did Dr. Simba receive a constructive dividend? Whether a constructive dividend exists turns on whether the distribution was primarily for the benefit of Lion Imaging and this Dr. Simba as its sole shareholder or for Lion Heart, since it derived as least some benefit from the improvements as they actually owned the building.
Case Details / Fact Pattern
Dr. Simba is a cardiologist who conducts his medical practice through Lion Heart. In 2003, Lion Heart leased a cardiac CT scanner from Narla Medical Solutions USA, Inc. (Narla), for a 60-month term. The estimated useful life of a CT scanner is generally assumed to be approximately 5 years. Dr. Simba signed the lease on behalf of Lion Heart, and the lease was secured by a $500,000 life insurance policy on Dr. Simba naming Narla as the beneficiary. The lease provided that Lion Heart could not assign or dispose of its rights or obligations under the lease or enter into any sublease without Narla's written consent. The lease also included an option to purchase the CT scanner at less than fair market value at the end of the lease thus making the lease a capital lease for financial reporting purposes.
In 2004, Lion Heart paid $4,000 to WRB Custom Constructions for construction work to accommodate the CT scanner. The construction work included erecting new lead walls to assist with the functionality of the scanner and housing the scanner on the bottom floor of Lion Heart's new two-story office. Also in 2004, Dr. Simba formed Lion Imaging, a limited liability company, to manage the CT scanner, Dr. Simba was the sole owner of Lion Imaging and one of its three managing members.
Lion Heart's Reported Income and Claimed Deductions
As sole owner and manager of Lion Heart and Lion Imaging, respectively, Dr. Simba maintained separated books for both entities. For the years at issue Lion Heart reported income generated by the CT scanner for patients' use of its heart scanning service, while Lion Imaging claimed depreciation deductions for the CT scanner. Lion Heart also claimed deductions related the CT scanner including: (1) salaries and wages of three employees involved in the operation of the CT scanner; (2) repairs and maintenance of the CT scanner and the office shared by Lion Imaging and Lion Heart; (3) monthly rental of the shared office; (4) depreciation of the office furniture in the shared office; (5) rental payments on the CT scanner lease; and (6) expenses for operating the CT scanner. In addition, Lion Heart was the sole tenant of the office space in which the CT scanner operated, and made the down payment and paid the construction costs related to the CT scanner. Simultaneously, Lion Imaging was claiming depreciation on the CT scanner as if it owned the scanner.
For the years as issue the Simbas and Lion Heart has the same accountant prepare their tax returns.