Leasing Office Equipment: Advantages and Disadvantages
Leasing companies should be seen as potential suppliers for virtually all of your equipment and other tangible business assets. Leasing companies will lease or rent motor vehicles, office furniture, store fixtures, computers, communications devices, manufacturing equipment, and other items you may need to run your business. However, before you make a decision, you should determine if you would be better off leasing an asset instead of purchasing it.
Basic Leasing Terminology
Leases and rentals are contractual arrangements by which the owner of 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.
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.
A lease that is used to effectively finance the purchase of assets is commonly referred to as a "financial" (or "financing" or "finance") lease. The distinguishing characteristics of financial leases are that (1) the duration of the lease generally coincides with the functional or economic life of the property, (2) the lease may not be canceled, and (3) 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).
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 lease arrangement.
Reduced Initial Cash Outlay
A reduced initial cash outlay is a primary advantage of leasing. Your cash may be better used for purposes other than buying equipment. As for purchase loans, lenders frequently require down payments of up to 25% or more.
Easier credit terms
You will have an easier time finding someone willing to lease you equipment than someone willing to extend you 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. If you are having financial difficulties, you may be able to negotiate a longer payment period and/or a more flexible payment schedule with a lessor than you would be able to negotiate under a loan agreement.
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 acquiring additional equipment or borrowing additional funds without the lender's permission.
Flexibility in addressing obsolescence
Leasing may enable you to better keep pace with improving technology. For computer 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.
If you're not sure whether you really need a particular item of equipment, leasing an item on a short-term basis will give 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.
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.
Your lease or rental payments are fully deductible if you use the leased asset in your business. However, you need to be aware that, in certain situations, the IRS may deny rental deductions if it audits your return and concludes that your lease is in reality an installment or conditional sale. Your should check with your tax attorney if you think your lease agreement may run afoul of the IRS. In considering whether leasing will provide an actual tax advantage, you need to weigh the corresponding disadvantage of being denied any depreciation deductions with respect to the leased property.
Balance sheet appearance
Leasing may improve such financial indicators as your debt-to-equity and earnings-to-fixed-assets ratios. The improvement occurs if exclude your leased assets and the 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.
The disadvantages of leasing your equipment and other business assets are:
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. Your rental payments compensate the lessor not only for acquisition and financing costs, but also for the lessor's retained risk of continuing ownership. You must also pay for the insurance and taxes on the asset which increases the installment payments and overall cost of the equipment.
No ownership interest
Your lease payments generally do not establish any equity in your leased equipment. 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 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 are either non-cancelable or impose a stiff penalty for early termination.