Leasing equipment to meet your business needs is a viable alternative to purchasing equipment and sometimes the only recourse for a new business or those in a cash or credit crunch.
Depending on the type of equipment your business needs, as well as the shape of your business finances, leasing your business equipment could be a good fit. And if yours is a start-up business that is strapped for cash or if you are finding it difficult to secure the credit necessary to finance your purchases, leasing may be your only real option for acquiring needed business assets. However, even if this isn't the case, you should view leasing companies as potential suppliers for virtually all of your equipment and other tangible business assets. You should have little trouble finding companies willing to lease or rent vehicles, office furniture, store fixtures, computers, communications equipment, manufacturing equipment, and other items you may need.
The trick, of course, is determining when you would be better off leasing an asset instead of purchasing it. The main advantage of leasing is that you can generally gain the use of an asset with less of an initial expenditure of cash than would be required if you purchased the asset. Equipment leases rarely require down payments. In other words, leasing may effectively provide the benefit of up to 100 percent financing (although a refundable security deposit may be required in some instances). In contrast, purchase loans frequently require down payments of up to 25 percent or more.
Before you sign on the dotted line, consider the following issues:
- Familiarizing yourself with basic leasing terminology
- Advantages and disadvantages of leasing
- How to compare purchase and lease costs over the life of the asset
- How to shop for a lease that meets your specific needs
- Tax implications of leasing
Basic leasing terminology
Leases and rentals are contractual arrangements by which the owner of the property (the "lessor") allows another person (the "lessee") to use the property for a stated period of time in exchange for cash payments or other compensation.
There is no real legal distinction between a "lease" and a "rental." In practice, however, rentals generally are considered short-term arrangements (a day, a week, a month), while leases are arrangements for longer terms (a year or more).
The two main types of equipment leases you'll encounter are "true" leases and "financial" leases. You also may hear about "sales and leaseback" leases, which in reality are sophisticated financing transactions.
True leases. If the lessee acquires no rights to the property other than its use, then the lease is commonly referred to as a "true" (or "straight") lease. Under a true lease, the lessor is treated as the owner of the leased property for both tax and non-tax purposes, and the lessee's rental payments do not establish any equity in the property. A true lease usually gives the lessee the option to prematurely end the lease, subject to conditions that are spelled out in the agreement.
If the lessor remains responsible for maintaining the property, then a true lease also may be referred to as an operating (or "maintenance") lease. Similar in meaning is a "gross" lease, under which a lessor is responsible for paying all maintenance, insurance, tax, and similar expenses associated with the leased property. In contrast, under a "net" lease, the lessee is responsible for such expenses.
Financial leases. A lease that is used to effectively finance the purchase of assets is commonly referred to as a "financial", "finance" or "capital" lease. The distinguishing characteristics of financial leases are that:
- the duration of the lease generally coincides with the functional or economic life of the property;
- the lease may not be canceled; and
- the lessee is responsible for maintaining the property.
Frequently, a financial lease will be structured so that the lessee's only practical choice at the end of the lease is to purchase the asset. For example, the parties may agree at the inception of the lease that the lessee will purchase the asset for a specified price (this type of lease is effectively a conditional sales agreement). Or perhaps the lease gives the lessor the right to compel the lessee to purchase the asset or provides the lessee the option to purchase the property for a nominal price.
For accounting and tax purposes, financial leases are generally treated as a sale.
Sale and leaseback leases. Under a "sale and leaseback" arrangement, the owner of an asset sells the asset to a third party and then immediately leases it back. The benefit of this transaction is that the owner frees up the cash that was tied up in the asset (through the sale) while still retaining its use (through the leaseback).
True lease vs. financial lease. To a large extent, your expected need for the leased equipment will determine whether you end up with a true lease or a financial lease. If you expect to need the equipment for most, if not all, of its useful life, then you'll probably end up with a financial lease. In contrast, if you expect that you'll need only the equipment for a specified period and that the equipment will be of use to someone else at the end of that period, you probably can find a lessor who's willing to set you up with a true lease arrangement.
Understanding key lease terms
Here are some of the major terms commonly found in equipment leases of which you should be aware:
- Lease term. Identifies how long the lease will be in effect. If you suspect that your need for the equipment may exceed the initial term, try negotiating the inclusion in the agreement of a renewal option that entitles you to renew the lease for a specified period or periods and for a specified rent.
- Rental rate. Identifies how much the rent is and when it must be paid. Most leases also include late payment provisions that impose an additional charge if you fail to pay the rent when it's due or within a specified grace period. If your business experiences seasonal or irregular sales activity, try negotiating a flexible rental rate that corresponds to the changes in your cash flow.
Although not always explicit in nature, the rental rate for equipment leases frequently has an interest component. Accordingly, when interest rates drop, lease payments may also drop on new equipment leases. Following an interest rate drop, check to see if your lease can be modified. If the lease cannot be modified due to an expensive cancellation provision, investigate buying out the lease with less costly bank financing.
- Maintenance. Identifies who is required to maintain the equipment. Be wary about accepting a requirement that you provide a higher degree of maintenance than would be required if you owned the equipment.
- Improvements and modifications. Identifies whether you have the right to make improvements or modifications to the equipment so that it better suits your needs. Depending on the equipment involved, you may want to specify who's responsible for modifications required by federal or state regulatory agencies.
- Insurance. Identifies who is required to insure the equipment, as well as who is entitled to what part of any settlement if the equipment is lost, stolen, or damaged.
- Stipulated losses. Specifies amounts you'll owe if the equipment is lost, stolen, or destroyed by casualty. Such amounts may be in addition to or in lieu of the value of the equipment.
- Purchase option. Identifies whether you'll have the right or obligation to purchase the equipment. The provision should specify an option price or range and how and when the option may be exercised.
- Transfers. Identifies whether you or the lessor has the right to transfer your respective interests in the lease. You want to be sure that a transfer by the lessor will in no way infringe upon your expectations under the lease. You'll also want to check under what conditions, if any, you'll be able to sublease the equipment to others.
- Claims. Identifies whether you can sue and take other actions in the lessor's name to assert claims against suppliers and others with respect to the equipment and whether you're entitled to retain any settlements from such actions.
- Early termination and amendment. Identifies under what conditions the lease may be amended or canceled. These provisions become more important as the term of the lease increases. Try to forecast the circumstances under which the equipment may become uneconomical or useless to you (for example, the adoption of a law that makes your use of the equipment illegal, a technological advancement that makes the equipment obsolete, etc.), then try to negotiate a provision that addresses those circumstances.
- Modern equipment substitution. Provides for updating the equipment or replacing it with a newer model during the lease term. This is an especially useful provision to have included in a lease for computer equipment, communications devices, and other items that are subject to rapid technological advancements.
- Termination costs. Identifies who is responsible for the costs (dismantling, packing, shipping, insurance, etc.) related to returning equipment to the lessor at the end of the lease term.
- Master lease. Identifies that additional equipment can be leased by an addendum to the agreement that describes the new equipment, the rental rate, and the lease term. This type of provision can yield substantial savings in negotiation costs if you expect an ongoing relationship with the lessor.
Business equipment leasing advantages
There are numerous advantages to leasing your equipment and business assets, ranging from less financial impact to flexibility in addressing the need and suitability of equipment:
- Reduced initial cash outlay. The main advantage of leasing is that you can generally gain the use of an asset with less of an initial cash expenditure than would be required if you purchased it. Equipment leases rarely require down payments.
- Easier credit terms. You'll likely have an easier time finding someone willing to lease your equipment than finding someone willing to extend your credit to purchase the equipment. One reason is that with a lease, title to the property remains with the lessor so if you miss some payments, the lessor can quickly get the equipment back. Furthermore, under a lease, you may be able to negotiate a longer payment period (resulting in reduced payment amounts) and/or a more flexible payment schedule (resulting in a better matching of your payment obligations with your cash flow) than you would be able to negotiate under a loan.
- Avoidance of financial restrictions. An equipment lease rarely includes any provisions that restrict your future financial operations. In contrast, it is not uncommon for a loan agreement to include restrictions on your ability to acquire additional equipment or to borrow additional funds without the lender's permission.
- Flexibility in addressing obsolescence. Leasing may enable you to better keep pace with improving technology. For computers, communications devices, and other equipment that is subject to rapid technological improvement, you'll have an easier time convincing yourself to invest in updated equipment if you acquired your existing equipment under a short-term lease or a lease that includes an equipment substitution provision.
- Flexibility in addressing need and suitability. If you're not sure whether you really need a particular item of equipment, leasing an item on a short-term basis will provide you the opportunity to evaluate the item's utility to your business without committing to a substantial investment. You can also use short-term leases as a way to test and compare different brands and models.
- Maintenance support. Under some leases, the lessor may agree to be responsible for maintaining and repairing the leased equipment. Although the cost of this service will usually be factored into your rental payments, you'll at least avoid the problems of having to find qualified repairpersons and of being burdened with unplanned repair costs. Furthermore, a responsive lessor who is familiar with the equipment being leased can significantly reduce your equipment's downtime when repairs are necessary.
- Current deductibility of rent. Leasing provides a potential tax advantage in that your lease or rental payments are fully deductible if you use the leased asset in your business. In considering whether leasing will provide an actual tax advantage, however, you need to weigh the corresponding disadvantage of being denied any depreciation deductions with respect to the leased property.
- Balance sheet appearance. A frequently mentioned advantage of leasing is that it may improve certain financial indicators, such as your debt-to-equity and earnings-to-fixed-assets ratios. The improvement occurs if you're able to exclude your leased assets and their corresponding rental obligations from your balance sheet but do include the earnings the assets produce (net of rent expenses) on your income statement. The actual benefit of the improved indicators may be negligible since careful lenders will likely equate your lease commitments with long-term debt obligations. Current accounting rules have also eroded this benefit by requiring you to report on your balance sheet assets leased under many financial leases.
Leasing disadvantages and comparisons with purchasing
There are some disadvantages to leasing your business equipment. Comparing the leasing vs. the purchasing of your business equipment can help you decide which is the better choice for your business needs.
Disadvantages of leasing business equipment
The disadvantages of leasing your equipment and other business assets include the following:
- Overall cost. The biggest disadvantage of leasing is that your costs over the life of the asset are generally going to be higher than if you purchased the asset. This is because your rental payments must compensate the lessor not only for acquisition and financing costs, but also for the lessor's retained risk of continuing ownership. Performing a thorough cash analysis is useful in estimating the actual cost differential between leasing and purchasing.
- No ownership interest. Your lease payments generally do not establish any equity in your leased equipment. In other words, at the end of the lease, you won't have a tangible asset to show for your payments. This can be especially painful if you've grossly underestimated what the equipment would be worth at the end of the lease. Negotiating a purchase option under which a portion of your lease payments are credited to the purchase price is one way to effectively create equity in the leased property.
- Lost tax benefits. Assuming that the IRS doesn't recharacterize your lease as a purchase for tax purposes, a potential disadvantage of leasing is losing the tax benefits of depreciation deductions that come with ownership. This disadvantage may be insignificant, however, if the "lost" benefits are offset by your ability to deduct your rental payments or if you have insufficient income or tax liability to be offset by the lost deductions and credits.
- Commitment to property. Once you sign a lease agreement, you're generally committed to making payments for the entire lease period even if you stop using the property. Most equipment leases either cannot be canceled or impose a stiff penalty for early termination.
Leasing and purchasing compared
The main advantage of leasing is that your initial outlay of cash to gain the use of an asset is generally less for leasing than it is for purchasing. However, perhaps the main disadvantage of leasing is that you usually end up paying out more over the asset's life than you would have paid if you purchased the asset. How do you reconcile these two factors? Well, one way is to do a mathematical analysis of your net cash flows that would result from leasing and from purchasing.
Using a cash flow analysis. A cash flow analysis provides an estimate of how much cash you would need to set aside today to cover the after-tax costs of each acquisition alternative. The analysis takes into account the "time value of money," which is basically the concept that you don't need to have $50 today to pay a $50 expense in one year, due to the fact that you can earn interest on your money. To perform the analysis, you need to know or assume certain facts, including:
- purchase and financing terms
- lease terms
- your combined federal and state income tax rate
- the asset's expected useful life to your business (for depreciation purposes)
- the asset's estimated value, if any, at the end of its useful life to your business
- your cost of capital
- any other costs that you would incur if you leased the asset but not if you purchased it, or vice versa (for example, you'd need to account for expected maintenance costs if the lessor was assuming responsibility for those costs)
Consult our case study for an example of how you'd go about doing a cash flow analysis for purchasing vs. leasing an asset.
Finding the right equipment lease
The process for finding a good leasing arrangement for your business equipment is really no different from the process for purchasing equipment. The first step is to determine as nearly as possible exactly what you need and how much you're willing to pay. Once that's done, you need to devote some time to shopping around to find the best deal for your money.
Locating an equipment lessor
Finding an equipment lessor shouldn't be too difficult. In addition to companies that specialize in leasing equipment, many of which are subsidiaries of banks, insurance companies, and finance companies, more and more manufacturers are now offering leasing plans. Check your local Yellow Pages and online, and you're sure to find a number of leads.
You also may want to contact the American Association of Equipment Lessors, which is one of the industry's major trade organizations, for information about leasing companies in your area and about equipment leasing in general.
To ensure that you'll have meaningful information to compare, provide each company with a written statement that details what you're after. This can go a long way toward getting you quotes that are for the same equipment, have the same features and are on the same terms. Obviously, as you compare quotes, you're going to pay careful attention to how much rent each company is proposing to charge. However, you'll also do well to look into each company's reputation for dealing with its lessees. Most equipment leases will bind you into a relationship for a number of years, so you want to be sure that your lessor is going to treat you fairly and be responsive to your needs. If possible, get references from former and present customers of the company. It also wouldn't hurt to check the company's status with the Better Business Bureau or similar agencies in your area.
The formal lease agreement
Once you have a quote that you feel is worth pursuing from a reputable company, you need to reach a formal agreement on a lease with the company. Depending on your bargaining position, you may or may not be able to negotiate changes to the company's standard lease agreement. However, it generally doesn't hurt to ask, so if there's a provision in the agreement that you're uncomfortable with or if you have a provision you'd like to see added, make your concerns known. In any event, do not sign the lease until you are comfortable that you fully understand all of its terms. If the lease involves a significant commitment on your part, either in money or in time, have your attorney review it and advise you on any of its potentially adverse provisions.