As a small business owner, it can be very challenging to raise capital for the equipment you need to start or grow your business. Because of this challenge, many business owners look to leasing as a way to bridge the gap, but is it the best choice in the long-run? Should I lease a car in my business? Let’s take a look at what leases are and what types of leases are available, then how they compare, financially, to purchases.
What is a lease, really? According to Webster, it’s “a contract by which one party conveys land, property, services, etc., to another for a specified time, usually in return for a periodic payment,” but this definition is a simple one and does not address many of the other elements typically involved in leasing equipment. A better definition for the purposes of our discussion would be “a long-term agreement to rent equipment, land, buildings, or any other asset. In return for most (but not all) of the benefits of ownership, the user (lessee) makes periodic payments to the owner of the asset (lessor). The lease payment covers the original cost of the equipment or other asset and provides the lessor a profit.”
Should I lease a car in my business? Sales representatives will often advise a business owner that leasing is a “better deal” because “it’ll be fully deductible on your taxes.” While the tax implications may be an important factor in your decision making process, it’s best to truly understand all of the other implications as well before determining the best course of action for your business.
If you’ve leased equipment before, you might already know that there are two main types of equipment leases, capital leases and operating leases, so beyond the lease or purchase decision, you also have compare the types of leases and determine the benefits and draw-backs in your particular situation.
A capital lease is one that is treated as a purchase. The asset and a related liability must be booked on the balance sheet. If any one of the following criteria is met, a contract is considered a capital lease:
Life of the lease is 75% or more of the asset’s useful life.
Lease contains a bargain purchase agreement (a purchase agreement for less than the market value of the asset at the end of the lease – often times $1.00).
Lessee gains ownership at the end of the lease period.
The present value of the lease payments is greater than 90% of the asset’s fair market value
If an entity has existing debt on the books with covenants requiring a certain level of return on assets, a capital lease may not be the answer because of the effect it would have on such a ratio. On the other hand, a capital lease may be very attractive in an industry where minimal technological improvements/changes are expected because it would allow an entity to obtain equipment without going through the same level of underwriting and scrutiny that might be required with traditional debt.
An operating lease is one in which the conveyance of property is treated like a rental. No asset or liability is recorded on the balance sheet; the periodic payments are simply expensed on the income statement and reduce net income each period. Operating leases are sometimes referred to as “off-the-balance-sheet financing.” This type of contract allows the entity to use the asset, but does not convey the rights of ownership to the asset. The property, at the end of the lease, is returned to the lessor, and, often, the lessee is given the opportunity to purchase the item leased at fair market value.
If technology is expected to change rapidly, operating leases can be a good way for small businesses to stay competitive without being bogged down by worthless outdated equipment. An operating lease allows for more flexibility than a capital lease, because the lessor is not committed to ownership of the equipment at the end of the lease term.
With regard to the idea that leases offer tax benefits, is it better to buy or lease equipment for my small business? The lease versus purchase decision should take into consideration the timing of your income. If you have a great year revenue-wise and you need some expense to offset that income, then doing a capital lease or purchase of assets makes sense because it’s likely that you’ll be able to take bonus depreciation on the property. Further more, if you anticipate additional growth in your business that will necessitate more equipment to meet rising demand, purchasing is a good idea for tax purposes. If you anticipate that your revenue will be steady over the coming 3-5 years, then you may want to enter into an operating lease because the expense will be spread evenly over time and will not cause significant fluctuations in your taxable income.
Read about the Section 179 Trap in this article
Now that we’ve got a context for discussing leases in comparison to purchases, let’s take a look at the similarities and differences:
Type PeriodicPayment Significant CapitalUp-Front Own Equipment Affects FinancialRatios
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Making the “right” decision when acquiring equipment will require unique analysis for each business and situation. It’s not as simple as should I buy or lease vehicle for small business. It is always recommended to seek the guidance of your accounting professional to assist in assessing your circumstances to determine which option, lease or purchase, is best for your business.
For professional advice from our Tulsa accounting experts, contact our offices in OKC: 405-288-1206 or Tulsa: 918-209-3441 for help today!