To Buy Or Not To Buy Equipment?
Leasing equipment has long been a popular means of reducing business costs, and -- contrary to many predictions -- the 1986 Tax Reform Act has sparked additional interest in the technique. Granted, the law did increase the aftertax cost of leasing. For many companies, however, it has increased the cost of buying even more, thanks to the repeal of the investment tax credit and the lengthening of depreciation schedules for some equipment.
The new tax law also contains a sleeper many company owners don't yet fully appreciate -- the alternative minimum tax (AMT). The AMT, intended to keep taxpayers from reducing their tax bills to zero, imposes a 20% tax on many common tax deductions, newly defined as "tax-preference items." The AMT doesn't apply to S corporations, but it does apply to individuals, so all businesses are likely to be affected. And it could easily increase your tax rate by 10% or more. Managing the AMT will, for some companies, be another reason to lease rather than buy. If you don't own equipment, you don't generate depreciation deductions, so you reduce your exposure to AMT liability.
Depreciation deductions increase your AMT liability two ways. Congress mandated more aggressive depreciation for much equipment put into use after 1986; a certain portion of this accelerated depreciation is considered a tax-preference item and thus is subject to the AMT. Also, depreciation schedules used for computing taxable income tend to be more liberal than those for general accounting purposes, often making taxable income lower than book income. Starting this year, half the difference between taxable and book income will be subject to the alternative minimum tax. Properly structured lease payments, on the other hand, aren't tax-preference items subject to the AMT; they are fully deductible as a business expense.
Reducing your AMT liability may make leasing an especially attractive option now, but leasing has long offered several other advantages. It is often the cheapest type of financing, since many major leasing companies -- affiliated with manufacturers, banks, or insurance companies -- can borrow at a lower rate than you can. By leasing, they have acquired a lower effective borrowing rate than they would have paid had they borrowed to buy equipment.
When you're comparing leasing with buying, you generally expect your lease payments to be lower than the payments you'd make if you borrowed money to buy the same equipment. Your lessor can take advantage of depreciation deductions you may not even want, and the benefit should be passed on to you in lower costs. At the end of your lease term, moreover, the equipment you return is likely to have residual value -- that is, the lessor can sell it -- and this value should reduce your lease payments. In your lease-or-buy comparison, you should also consider the tax benefits that apply in each case, as well as any maintenance costs. For major acquisitions, evaluate your ability to use depreciation in the future as well as now. If your analysis shows the cost difference between leasing and buying to be small, then noneconomic considerations may be decisive.
One of these is flexibility. With leasing, you gain options that may come in handy if your business is likely to change. For instance, according to Ron Chamides, general manager of General Electric Credit Corp., more and more construction companies are leasing their heavy equipment. They prefer a relatively short lease that will permit them to jettison equipment they may not need when their current projects are completed. The same rationale would serve any company that operates in a volatile market, has changing equipment needs, or uses equipment that quickly becomes outdated.
By leasing equipment, you also pass on to the lessor the risk of estimating and collecting residual value. You don't have to worry about finding a buyer for equipment you want to replace. Of course, you pay for transferring this risk, but since a leasing company is likely to be more active in the market than you are, its costs are lower, and you benefit. This is why, for example, many companies choose to lease the automobiles they provide their employees.
If you want to leverage your capital and improve your balance sheet, leasing may be the way to go. Chances are, if you buy equipment you'll borrow at least part of the cost, incurring a liability that reduces your credit line. But so-called operating leases, usually short term, can be structured so that payments are simply another monthly expense -- the leases aren't recorded as a liability on your balance sheet. Thomas Sherman, a partner with Coopers & Lybrand in Minneapolis, tells of a midsize food-processing company that chose this route. The company needed a piece of equipment that cost about $300,000. It had good relations with its bank and a good credit rating. Borrowing the money it needed to buy the equipment would have been easy, but it was about to approach its major lender to negotiate a lower rate and longer commitment. Borrowing at that juncture would have made negotiations more difficult. So the company decided to lease. The lesson: leasing can help you conserve your borrowing power for situations in which you really need it.
Leasing may also offer immediate cash-flow advantages. If you borrow to buy equipment, you're likely to have to use your own money for part of the purchase price -- up to 20% is common. While some leasing companies require advance payments or a security deposit, you may be able to get 100% financing if your credit is good. You won't have to put anything down; just make your monthly payments when they come due.
Partnerships may find a special advantage in leasing. The Internal Revenue Service could treat the money that a partnership borrows to buy equipment as income the partners should be taxed on -- even though it's not distributed. Lease payments would be just another reductible expense.
Despite its many advantages, leasing isn't for every company, or for every piece of equipment. An important consideration is how long you plan to use the equipment. The more likely that you'll use it for its entire life, the less likely that leasing will make sense. Keep in mind, too, how important each kind of equipment is to your business. You may find that some equipment is so critical to your operations that you'll opt to buy for greater certainty and control.
Timing is also a factor in deciding whether to lease or to buy. The Tax Reform Act has a provision to keep companies from claiming a full year's depreciation for equipment they put in service late in the year. Instead, most businesses will have to figure their depreciation as if they put a piece of equipment into use halfway through the year, no matter when they actually do. But if you put more than 40% of your equipment into service during the last three months of your tax year, the law requires that you treat all equipment purchased that year as if it were put into use halfway through the quarter you actually start to use it. Thus your depreciation on equipment bought in the last quarter wouldn't be based on six months of use, but on a month and a half. To keep under the 40% limit and preserve your deductions, you may want to lease whatever additional equipment you need during your last quarter.
To make sure your lease payments will be fully deductible -- one of leasing's fundamental advantages -- your contract must conform to certain IRS guidelines, assuring that, for tax purposes, you'll be treated as a lessee rather than as the owner.
* Term of leases. It can't be more than 80% of the remaining estimated useful life of the equipment when your lease begins. This includes any renewals or extensions at a fixed lease payment. Moreover, at the end of your lease term, the equipment must have at least a year of useful life remaining.
* Estimated residual value. At the end of your lease term, the equipment must be worth at least 20% of what it was when your lease began.
* Purchase option. You cannot have a fixed-price purchase option to buy leased equipment. You or any related entity may have only an option to buy at fair market value, which is determined when you are ready to buy.
* Investment in leased property. Neither you nor any related entity can pay for or guarantee payment of any part of the price paid by your lessor for the equipment you lease. Basically, this means you can't own the equipment you lease, even in part or indirectly.
* General-use property. Somebody besides you or an entity of yours must use the kind of equipment you lease. In other words, there must be a market for it.
If your lease doesn't meet these guidelines, the IRS could view your arrangement as a loan rather than a lease and treat you as owner of the equipment. You'd be entitled to deduct only the portion of your payments that the IRS decides goes for interest. As owner, you'd have to claim depreciation, so you also might be liable for the alternative minimum tax.
Not part of the IRS guidelines, but important to protect you, is negotiating a clause that terminates the lease if your equipment is damaged beyond repair. (You'll probably have to pay the lessor a fee, called casualty value, in exchange for the termination clause.)
If, after considering the advantages and disadvantages, you decide to lease, you should give careful thought to choosing a leasing company. Some are closing down because they made leases largely on the basis of the investment tax credit and higher tax rates, both now gone. Some are merely financing conduits, which quickly sell transactions to equity investors for a fee. This can create tax problems for your company since the IRS could claim this is not a true lease. And this kind of arrangement could leave you trying to deal with passive investors during the term of your lease. If, like many company owners, you want service and continuity in your relationship with a lessor, you should look for a company with a reputation for stability, and one that is not highly dependent on the old investment tax credit and faster depreciation schedules. Such a company is more likely to be around when you need to upgrade your equipment.
You can often get attractive rates from leasing companies that are looking for depreciation. For instance, the 1986 Tax Reform Act eliminated certain tax breaks that insurance companies, regional banks, and savings and loan associations used to rely on, and they're expected to move into the leasing market in a big way. Some leasing companies can offer better terms because they specialize in certain kinds of equipment. In computer leasing, for example, a lot of companies were burned by the rapidly changing market and got out of the business. The ones that survived learned how to estimate residual value despite the fast-changing technology. Since they're confident of their ability to dispose of equipment after a lease expires, they can offer a rate that doesn't include a large cushion for error.
Major leasing companies can offer good terms for the same reason. They have whole divisions that specialize in marketing old equipment, cars, telecommunications systems, aircraft, oil-drilling rigs -- you name it. To attract new customers in a competitive marketplace, some major leasing companies also offer access to service facilities and let you benefit from the discounts they get on bulk purchases of replacement parts. This will help you realize savings ordinarily available only to large companies. If you're considering this kind of lease, compare your leasing costs with the cost of leasing elsewhere, plus the cost of a service contract.
Leasing from the equipment manufacturer can offer advantages, too. Manufacturers often provide financing as a way to maintain customer contact. They make it easy to finance upgrades and improvements, and they provide trade-in programs allowing you to exchange your equipment for something more advanced before the end of your lease term. And, since manufacturers sometimes use their leasing programs as sales tools, they may have more relaxed credit standards than independent leasing companies. Be aware, however, that not all manufacturers offer true "tax-oriented" leases. Although they are called leases, these arrangements often are conditional sales agreements, and the lease payments may not be fully deductible. You could be exposed to the AMT.
In negotiating any lease, you need to think ahead. Tax rates may rise in the near future, or the investment tax credit may be restored. Your lessor would benefit from both developments, and you should negotiate a lease that will allow you to share in those benefits.
Overall, the basic rules about leasing haven't changed much. For many companies, nontax considerations continue to be the most important. Leasing is a financial strategy that allows you to acquire the use of assets, while investing your own scarce resources in assets more likely to appreciate. It can help you lower your cost of capital and preserve flexibility, vital to your success in volatile, competitive markets.