New rules may make a difference in your decision.
Whether to buy or lease new equipment is a tough question for many specialty fabric professionals to answer, even as credit becomes more readily available. There is no one correct answer to fit every situation or business, but compared to the simplicity of buying, leasing is more complicated and may be getting more complex.
Current lease accounting rules may be changing as a result of ongoing negotiations between the International Accounting Standards Board (IASB), which sets rules for many countries around the globe, and the U.S. Financial Accounting Standards Board (FASB), which writes the rules in the United States. The proposals would require many businesses to add all but the shortest leases to their balance sheets as liabilities, much like debt.
Equipment leasing is similar to a loan in which the lender buys and owns equipment and then “rents” it to a fabricating business at a flat monthly rate for a specified number of months. Although lease financing is generally more expensive than bank financing, in most instances it is more easily obtained.
Among the reasons given by small business owners for leasing are the ability to have the latest equipment, consistent expenses for budgeting purposes, help in managing company growth and no down payment.
Leasing offers real advantages, including reduced cash outflows and greater control.
A short list of leasing advantages:
- Conventional bank loans usually require more money upfront than leasing;
- Leasing generally requires only one or two payments up front in lieu of the substantial down payments often required to purchase equipment.
- Unlike some financing options, leasing offers 100 percent financing. That means a fabric products business can acquire essential equipment and begin using it immediately to generate revenues, with no money down.
- Leasing provides a hedge against technology obsolescence by allowing a business to upgrade its equipment at the end of the leasing term.
- At present, an operating lease is not considered long-term debt or liability, and does not have to show up on the business’s financial statements. This makes the business more appealing to traditional lenders in the future when cash is needed.
- Operating lease payments are generally treated as fully deductible business expenses. Consult a tax professional to determine what percentage of other types of leases can be deducted.
- Best of all, the full amount of the equipment, as well as service or maintenance, can be included in the lease. This spreads the cost over the term of the lease, freeing up cash flow when needed.
Ownership and tax breaks make buying business equipment appealing, but high initial costs mean this isn’t an option for everyone. Chief among the advantages of buying equipment is, of course, that the business owns it. This is especially true with property that has a long useful life and is not likely to become technologically outdated in the near future, such as office furniture or shop machinery.
There are disadvantages to purchasing rather than leasing equipment:
- Higher initial expense.Â For some fabricators and suppliers, purchasing needed equipment may not be an option because the initial cash outlay is too high. Even if the business plans to borrow the money and make monthly payments, most banks require a down payment of around 20 percent. Borrowing money may also tie up lines of credit, and lenders may place restrictions on the business’s future financial operations to ensure the loan will be repaid.
- Obsolete equipment. While ownership is perhaps the biggest advantage to buying equipment, it can also be a tremendous disadvantage. Purchasers of high-tech equipment run the risk that the equipment may become technologically obsolete, and they may be forced to reinvest in new equipment long before planned or budgeted. Certain types of equipment have little resale value. A computer system that costs $5,000 today, for instance, may be worth only $1,000 or less three years from now.
In the eyes of the IRS, whether a leasing transaction is treated as a lease or as a purchase determines who will be entitled to deductions for expenses such as depreciation, rent and interest expenses.
Generally, when it comes to determining who owns property for tax purposes, and thereby is entitled to the depreciation deductions, the IRS looks to the “economic substance” of the transaction—how it is structured and works—not how the parties involved characterize it.
Lease or rental payments are usually fully deductible. With a purchase, Section 179 of the Internal Revenue Code allows the business to fully deduct the cost of some newly purchased assets in the first year. In 2014 an operation can deduct up to $25,000 of equipment costs (subject to a phase-out if more than $2,000,000 of equipment is placed in service in any one year). Although not all equipment purchases are eligible for Section 179 treatment, the business can still receive tax savings for almost any business equipment through depreciation deductions.
Fortunately, there are no time limits on leasing. That means leasing can be effective when a business has already purchased equipment. These transactions, known as sale-leasebacks, are usually available for equipment purchased within the past 90 days. Sale-leasebacks may also be used to legitimately shift the tax benefits from the business to its new owner or owners.
Equipment or property that is already on the operation’s books can be sold to the owner/shareholder or to key employees, and leased back to the business. Because these self-rental transactions involve shifting tax benefits from the business to its owners/shareholders, they should be “arm’s length” transactions, and the parties should be aware of possible IRS scrutiny.
Changes in the future
As proposed, the new rules would represent a major change in how most businesses account for the cost of leases, by requiring vastly larger amounts of assets and liabilities to be reported on the books. Under current rules, fabricators and suppliers are generally able to classify many leases as “operating leases” and keep them off their balance sheets.
This so-called “off-balance-sheet financing” can make a business look less indebted than it really is. The proposed lease accounting rules would require many businesses to add to their balance sheets all but the shortest leases, as liabilities akin to debt.
The proposal would also set up a two-track system for how lease costs should be reflected in business earnings. Costs of real estate leases would be recognized evenly over the term of the lease, while costs of other leases would be more front-loaded and would decline over the lease term.
Should these accounting standards be adopted as proposed, banks and other lending institutions would be affected first and hardest. With lenders forced to increase their capital and new restrictions on the sources of funds those institutions rely on, leasing could face a tighter market and become more expensive.
There will likely be a considerable delay in making the new rules effective, probably until 2017. This should give fabric product professionals time to comply and, in some cases, to renegotiate loan agreements. The many businesses that currently have borrowing limits and/or restrictions placed on them by lenders and investors could, once leases must be included on the balance sheet, be in violation of those agreements.
Anyone can analyze the costs of leasing versus purchase with a so-called discounted cash-flow analysis, comparing the cost of each alternative by considering: the timing of the payments, tax benefits, interest rates on a loan, the lease rate and other financial arrangements. But while this sort of analysis is useful, the lease/buy decision can’t be made solely on cost analysis figures.
Generally, fabricators and suppliers with a strong cash position and good financing options can often buy needed equipment outright, or they can borrow to acquire equipment with a long operating life. If obsolescence is a concern, a short-term operating lease often provides the biggest advantage and the most flexibility.
If cash flow is an issue and the equipment must remain operable for longer periods, a long-term capital lease with a final residual payment will result in lower monthly payments plus a purchase option. However, short-term savings may result in higher costs over the entire leasing period. This is especially true with a finance lease where the user can purchase the equipment at the end of the lease. The business may end up paying more over the long term. It pays to determine any end-of-lease costs beforehand.
Although taxes play a role in whether to lease or to purchase, they should not be the deciding factor. Since a startling eight out of ten businesses lease some equipment, it makes sense to have your accountant investigate all the financial (and operating) benefits before making a decision.