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.
