Part One - Introduction
The term Equipment Leasing covers the various ways a business uses leasing to obtain needed equipment. Although there are various types of leases, terms, and even reasons why a business would lease equipment, the basic premise remains the same – a lease agreement is used to obtain equipment.
Leasing has proven to be very popular with businesses – in fact, equipment leasing accounts for over $140 billion in volume per year, and is responsible for one-third of all external financing for capital equipment. Obviously, the idea has merit.
What types of businesses lease equipment?
All manner of businesses lease equipment, from small corner-store “mom and pops” to large corporations. In general, there are three common lease size breakdowns – Small Ticket (equipment retailing for under 100k - copiers, computers, small vehicles, etc); Medium Ticket (generally equipment over 100k, but less than 1 million); and Large Ticket (over 1 million – like an aircraft, etc).
Each market has differing high-level concerns – small ticket is typically more about convenience, while large ticket tends to concern itself more with tax advantages (however, even your average copier lease has tax advantages.)
Generally, the Lessor (this is who provides the equipment and the lease) is an independent third-party company that specializes in business equipment leasing. They purchase the equipment from the manufacturer/dealer, and then lease it to the end user (known as the Lessee).
A second type is what’s called a “Captive Lessor” – this is when an equipment manufacturer sets up their own leasing company to lease equipment.
A third type is your typical bank. However, it should be noted that many banks don’t get too involved in leasing.
Why Leasing??
Leasing equipment is generally considered favorable by many businesses because it allows them to obtain new or used equipment right away, without paying the full retail price. Instead, the payments are broken up over time.
There are also numerous tax advantages and strategies to leasing. It can get a little complicated in regards to the details, which we’ll also explore.
Payments and Residuals
A very simple way to look at a lease is that a Lessee “rents” equipment from the Lessor. Payments are usually made monthly, but can also have other terms (quarterly, yearly, etc.) The payments are typically fixed, but again, there are cases where the amounts can vary (as in step leases and skip leases).
Generally, lease payments are based upon residual value, which is the estimated value of the equipment after the lease term is up. Say a piece of equipment is $100,000, and a company wishes to lease it for five years – the lease payments are determined by the estimated value of the item after the fives years is over (say it’s $30,000). The remaining $70,000 is broken up into lease payments (and, of course, adding in whatever fees and such for the lessor.)
Now, of course, the residual value assumes normal wear and tear. Excessive use or wear and tear could result in a monetary penalty.
End of Term Options
There are several end of term options available, depending on how the parties structure the lease. The simplest is the closed-end lease, where the equipment is returned at the end of the lease, and no further transaction takes place.
Other options that may be available are to re-lease the same equipment, or the outright purchase of the equipment at either market rate (fair market purchase option) or at a fixed price agreed upon at the lease inception (fixed purchase option).
The flexible end of term purchase options make leasing very attractive to a company. In essence, they can lease a piece of equipment for several years, then buy it when the lease term is up. This allows more financial flexibility than if they purchased the equipment outright, and also allows the purchase to take place later on, at a lower price.
In addition to equipment, services and extras may be bundled into a lease (maintenance agreements, equipment swaps, software upgrades, etc.) [1]
Leasing: Book Accounting vs. Tax Accounting
There are generally two main types of accounting that businesses engage in – book accounting (how the company sees things) and tax accounting (how the IRS sees things). They each look at leasing a bit differently (and have different names for them), as outlined below:
How the IRS looks at Equipment Leasing
Generally, the IRS has two clarifications for leases:
A True Tax Lease (or “True Lease”) is where the lessor is the owner of the equipment (regarding federal income tax purposes) and receives the tax benefits of ownership, which includes depreciation and any tax credits.
A Non Tax Lease is more or less treated as if it were a purchase or a loan. In other words, the lessee receives the same tax benefits as ownership, including claiming depreciation and interest expense deductions. A Non Tax Lease may also claim deductions under US Tax Code Section 179.
How does the IRS determine which type of equipment lease it is?
A lease is NOT considered a True Tax Lease by the IRS if ANY of the following are true:
· Any part of the lease payment is applied to an equity position in the leased equipment.
· The lessee will acquire ownership (i.e.: title) of the equipment upon payment of a specified amount of payments he or she makes.
· Over the period of time the equipment is used, the total amount of the payments a lessee pays is an exceedingly large proportion of the total sum required to outright buy the equipment.
· The agreed upon lease payments exceed the fair rental value of the equipment.
· At the time any purchase option may be exercised, the title to the equipment may be acquired for an exceedingly small purchase option price in relation to the actual value of the equipment.
· Any portion of the lease payments are specifically designated as interest (or its equivalent.) [2]
How Book Accounting looks at Equipment Leasing
Under “Book accounting” (which uses Financial Accounting Standards Board [FASB] rules), leases are classified as either a Capital Lease or an Operating Lease for financial reporting purposes.
An Operating Lease is generally viewed as a rental. The leased equipment in question is neither shown as a liability nor an asset on the company’s balance sheet. This type of lease is always viewed as a “true lease” by the IRS, and the company (the lessee) cannot take the tax benefits of ownership. Important note: oftentimes, the term “FMV Lease” (Fair Market Value Lease) may be used instead of “Operating Lease”.
A Capital Lease is treated in the company books as a purchase. The leased equipment is shown as an asset and/or a liability on the lessee's balance sheet, and the tax benefits of ownership may be realized, including Section 179 deductions.
How does FASB determine which type of equipment lease it is?
An equipment lease is NOT considered an Operating Lease by the FASB if ANY of the following are true:
· Ownership of the leased equipment automatically transfers to the lessee at the end of the lease term (or anytime before).
· The lease contains a bargain purchase option for the equipment (less than market value.)
· The term of the lease is greater than (or equal to) 75% of the estimated economic life of the leased equipment.
· The present value of the equipment lease payments - at the beginning of the equipment lease term - is equal to or greater than 90% of the original fair market value of the equipment. [3]
True Tax/Operating Lease vs. Non Tax/Capital Lease
The general differences between the types of leasing (both in book and tax accounting) have to do with taxes and balance sheets. Each “side” has one lease (and they are similar on both sides as well) that is not reported on the balance sheet, and also has one lease that is reported, and can be used for tax purposes.
Thus, companies (usually larger companies) that are concerned with asset allocation, balance sheets, end of the year statements, and the like often prefer to utilize True Tax Lease or Operating leases (almost always the same thing); whilst companies that are more concerned with taxes prefer a Non-Tax or Capital Lease.
Part Two - Specific Advantages of Leasing Equipment
There are a myriad of reasons a business would lease equipment instead of buy it outright, but in general terms, the reasons can be broken down into seven categories:
1 – Technological
2 – Financial reporting
3 – Cash Management
4 - Income Tax
5 – Ownership
6 – Flexibility and Convenience
7 – Economic
Let’s take a brief look at all seven.
Technological
In regards to technological equipment, there is almost nothing worse than owning a piece of equipment whose time has passed. Leasing technological equipment (instead of buying it outright) protects a company against obsolescence in regards to the equipment.
There can even be provisions written into a lease to further protect against obsolescence. For example; takeout, rollover, and upgrade provisions can be written into a lease, meaning outdated equipment can be replaced, upgraded, etc within the confines of the lease agreement. In the case of a takeout or upgrade provision, outdated equipment can be replaced (or upgraded) as part of the lease agreement. In some cases, however, this may mean termination fees and payoffs. In that case, a rollover provision may be used which allows these fees to be “rolled over” into a new lease.
Financial Reporting
Many larger companies desire to keep as much liability off the balance sheet as possible. Thus, a true tax (or capital) lease is utilized. This keeps the equipment in general off the balance sheet (both as an asset and liability). Furthermore, the lease expense for an operating lease is generally less than the depreciation and interest expense of a capital lease. This boosts overall reported earnings, and helps a lessee report a higher return on assets (ROA).
Cash Management
Obviously, spreading lease payments over time helps free up cash. This is especially desirable with higher ticket items, and allows a business to obtain more sophisticated and efficient equipment than it might otherwise be able to obtain.
Additionally, equipment lease down payments are generally less than traditional financing down payments, further freeing up cash reserves. And leasing (especially in the case of adding upgrade or rollover provisions) also makes it simple to forecast future equipment expenses, making future revenue projections far easier.
Income Tax
One of the biggest advantages of equipment leasing is in the form of income taxes. Even with a tax or operating lease, the lease payments are tax deductable. And in the case of non-tax and capital leases, a business can even enjoy the tax benefits of ownership, without paying the full retail price of such. This includes tax deductions in the form of depreciation, or even the full retail price (explained in the Section 179 section below.)
Ownership
Many times, ownership is not feasible (or even desirable). After all, it’s usually the use of a piece of equipment that produces revenue, not the ownership of it. And today, many firms are recognizing that it’s advantageous to obtain the use of equipment at the lowest possible cost.
Leasing instead of owning also protects a firm against stranded assets, which is essentially a piece of equipment that is obsolete – the company owns it, it’s on the books as an asset, yet they get no use out of it. Leasing can help alleviate that, as ownership can remain with the lessor.
Conversely, at times, immediate ownership is desirable, but the ability to stretch out the payments for a pre-determined number of months/years makes leasing a very viable option.
Flexibility and Convenience
Obviously, equipment leasing is incredibly flexible. The myriad of lease types and payment options make for an extremely customizable method of obtaining needed equipment. If a company wants the benefits of ownership, there’s a lease available for them. If the company would rather the lessor take on the risks of ownership, there’s a lease available for them as well. There are purchase options, or the equipment can be returned.
In addition, leases can be structured to best serve the interests of both parties:
· A Step Lease is where the lessee’s payments either increase (step up lease) or decrease (step down lease) over the term to better meet the lessee’s cash flow constraints.
· A Skip Payment Lease allows the lessee to make payments during certain timeframes, but not on others. Examples might be a farmer who wants to make payments when cash flow is best (harvest time.)
· A Swap Lease allows the lessee to temporarily exchange equipment in need of repair.
· A Master Lease is an agreement that contains the boilerplate provisions of the lease, and allows further equipment to be added later (on a predetermined schedule), without changing lease terms.
As one can see, leasing can be tailored to almost any situation.
Economic
Almost a culmination of the advantages already outlined, many companies think leasing simply makes good economic sense. It can be less restrictive than traditional bank financing, almost always has better tax benefits, and also (if an independent lessor is used) allows a company to diversify its sources of equipment financing.
In addition, many independent lessors are not as restrictive as traditional banks are in terms of who can lease equipment. Many small businesses, for example, have found leasing to be the only way they can obtain the equipment they need to turn a profit. Also, while we are discussing the economic impact of leasing, we need to discuss Section 179.
Leasing and Section 179
Section 179 of the US Tax Code allows small and medium sized businesses to deduct the full retail purchase price of equipment in the tax year the equipment was bought and put into service.
As mentioned previously, many leases allow a business to enjoy the benefits of ownership. Hence, assuming a Non-tax or Capital lease, a business can actually deduct the FULL retail price of equipment they are leasing, despite only making lease payments. In fact, in many cases, the tax savings for a business have actually exceeded the amount of the lease payments, making equipment leasing profitable for the calendar year.
In addition, the Economic Stimulus Act of 2008 has increased the Section 179 limits, making it an even better deal in 2008. [4]
In Closing
Equipment leasing is a very popular way for businesses to obtain needed equipment (in fact, eight out of ten businesses lease equipment.) It is a relatively simple concept in an overall sense (making payments on the equipment), with a myriad of different flavors and options that make it an attractive option for almost any business or financial situation.
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