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Lease or buy, there is no free lunch.
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Today, the state of the economy has forced many lenders to stop or cut back on new loans. Those lenders still making loans have raised their requirements, resulting in a credit freeze for many small businesses. For most businesses the natural alternative is leasing.
During the past several years, leasing has been estimated to represent about 32 percent of private, nonresidential purchases of producers' durable equipment. According to Hoovers Rental equipment accounted for almost 40 percent of all equipment used by the US construction industry in 2006.
Part of this growth can be attributed to the advertising sizzle used by leasing advocates. Less capital outlay, frees up bank lines of credit and sometimes leases are promoted that the payments are tax deductible. While some of these statements may be true some of the time, not all of these statements are true all of the time.
Before analyzing these statements it is helpful to understand a few of the basics. There are many forms of leases. While the language of the agreement may be in lease terms with lessee and lessor verses loan terms of borrower and lender, in their simplest form they can be divided into financed leases or true leases.
Consider the acquisition of equipment with an original sticker price of $50,000.
A financed lease as the name implies, has the mechanics of financing. The payment to the lessee will be determined by the rate of interest charged, for the term of the lease selected based on the cost. At the end of the term the full balance will be repaid. Depending on the language in the lease there may be an option for the lessee to purchase the asset for a $1.00 or the asset may be abandoned by the lessor.
The true lease and the associated tax treatments are determined by the IRS and Financial Accounting Standards Board known as FASB. In general to be considered a true lease the lessor has to have an at risk exposure usually defined as 10 percent of the original cost or greater.
For the same $50,000 cost of equipment, the lease payments would be based on repayment of $45,000 over the selected term with an implied interest rate. The lessor must be at risk for at least $5,000. The result of this calculation usually provides a lease payment lower than in a financed lease. At the end of the term the lessee usually has several options, the right to purchase the equipment at fair market value, the right to release for an agreed upon term or turn in the equipment.
A comparison of some of the small details you should be aware of: …generally …
Sales tax is charged up front on the original cost for the financed lease. Under the true lease the sales tax is charged on the monthly payment. Personal Property Taxes are paid by the lessee, usually direct to the taxing authority under the financed lease and to the lessor in the true lease (subject to sales tax). The lessor is the owner of the equipment in a true lease taking all allowable tax write offs including depreciation, allowing the lessee to expense the lease payments. Again generally in a financed lease the lessee owns the equipment with the ability to expense depreciation and interest but not the lease payment.
So where does that leave the marketing sizzle?
If your credit is generally weak, the lessor will improve their position by requesting first and last payment or last two or three payments. (Sounds like a down payment.) They may even ask for your personal guarantee.
While a lease may be considered of balance sheet financing, it is an obligation which requires repayment. With a lease you may not have to access your bank line of credit to acquire the asset. But … do not think for a minute that your banker will not take the lease obligations into their consideration when your loan comes up for annual review.
Yes under certain conditions a lease payment can be expensed. Under ownership, the equipment can depreciated, in many cases using accelerated depreciation.
So, when is leasing a true advantage over financing or ownership? Consider when the technology changes rapidly. One of the biggest markets was and still is computers and the associated software. This also allowed the seller to provide service contracts and software upgrades. Another is when a project has a fixed start and end date, such as construction projects.
Leasing also exploded when many manufactures also created leasing companies to help promote and sell their product. This gave them greater control to take trade-ins and or upgrade their products. In some cases this has created an aftermarket of their product.
Today leasing is a big business. To stay in business, a free lunch is only available if the other party pays for it.
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