– By Mark Battersby –
Whether to buy or lease is a question facing many rural builders even as credit becomes more readily available. While there is no one correct answer that fits every situation nor every building business, compared to the simplicity of buying, leasing is far more complicated and may be getting more complex.
The lease accounting rules as we currently know them may be changing as a result of ongoing negotiations between the International Accounting Standards Board, which sets rules for many countries around the globe, and by the U.S. Financial Accounting Standards Board, 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 a strategy in which the lender buys and owns equipment and then “rents” it to a building 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 their operation’s growth and no down payment.
Leasing offers real advantages, including reduced cash outflows and greater control. But that’s not all. A short list of leasing advantages includes:
– Conventional bank loans usually require more money up-front 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 builder or contractor can acquire essential equipment and begin using it immediately to generate revenues with no money down.
– 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 for the building business now, when needed.
– Leasing provides a hedge against technology obsolescence by allowing a builder or contractor to upgrade its equipment at the end of the leasing term.
– At least for the time being, 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 down the road or when needed.
– Operating lease payments are generally treated as fully deductible business expenses. Naturally, a tax professional should be consulted to determine what percentage of other types of leases can be deducted.
Ownership and tax breaks make buying business equipment appealing, but high initial costs mean this option isn’t for everyone. Among the disadvantages of buying equipment are:
– Higher initial expense: For some builders or contractors purchasing needed equipment may not be an option because the initial cash outlay is too high. Most lenders require a down payment of around 20 percent.
– 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. Certain types of equipment have very 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.
Generally, when it comes to determining who owns the property for tax purposes, and thus who 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, of course, usually fully deductible. With a purchase, Section 179 of the Internal Revenue Code allows the builder or contractor to fully deduct the cost of some newly purchased assets in the first year. In 2014 the operation can deduct up to $25,000 of equipment (subject to a phase-out if more than $2 million of equipment is placed in service in any one year). Although not all equipment purchases are eligible for Section 179 treatment, the operation can still receive tax savings for almost any business equipment through depreciation deductions.
As proposed, new accounting rules would mean 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 an operation’s books. Under current rules, builders and contractors 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, however, require many businesses to add all but short-term leases to their balance sheets as liabilities akin to debt.
The proposal would also set up a two-track system for how lease costs should be reflected in the operations’ 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, it is the banks and other lending institutions that would be impacted first and hardest. With lenders forced to increase their capital and new restrictions on the sources of funds those institutions rely on, leasing might face a tighter market and become far more expensive.
Fortunately, there should be a considerable delay in making the new rules effective, probably until 2017. This would give builders, contractors and building businesses 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 building operation’s balance sheet, be in violation of those agreements.
Generally, builders and contractors 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 building business may end up paying more over the long term. Obviously, it pays to determine any end-of-lease costs beforehand.
Furthermore, although taxes play a role in whether to lease or to purchase, they should not be the deciding factor. Since a startling 8 out of 10 businesses lease some equipment, would your building business reap the long-term benefits of a lease?
Mark Battersby has more than 35 years experience in small business issues, tax and financial matters. Contact him at 610-789-2480 or MCBAtt12@Earthlink.net.