Lease versus purchase

Perhaps the most common tax issue for the growing business is the acquisition of equipment. Nearly every business has to decide whether to lease or purchase the equipment, and as with any business decision, there is no one “right” answer. The basic issues in making the lease/purchase decision should not be the tax issues, but the business and economic issues.

In some circumstances, a lease is the only alternative. If a company cannot afford to purchase the asset outright, or cannot get conventional financing, a lease may be the only alternative. Sound business practices may dictate using scarce working capital for purposes other than equipment purchases or the down payment on conventional equipment financing, again leaving the lease as the only viable alternative.

The effect on the company’s financial statements should also be considered. There are well defined criteria for determining whether a lease is an operating lease in which the lease payments are expensed, or a financing lease in which the lease is treated as an installment purchase, the equipment is capitalized and depreciated, and a portion of each lease payment expensed as interest. Even with an operating lease, however, future lease obligations must have footnote disclosure. The different options should be carefully considered as the type of transaction will impact reported income, and could alter key financial ratios that could be a part of a loan covenant.

The tax rules governing leasing are often the motivating factor in considering leasing. The results are similar to the financial statement rules–only the rules are not as clearly defined. If a lease is a true lease, all rental payments are deducted; if the contract is in reality an installment purchase, the asset must be capitalized and depreciated, with an additional deduction for the interest element of the contract. There are two additional factors that should be considered:

  1. Purchasing personal property provides the opportunity for qualifying businesses to deduct up to $500,000 of the cost of qualifying property acquisitions in 2013.
  2. Leasing will not yield significantly higher deductions for the business use of “luxury automobiles” than are available through depreciation. To equalize the purchase and lease treatment of such automobiles, taxpayers are required to add to their income for each year the lease is in effect an amount determined from an IRS table based on the value of the automobile at the lease’s inception.

If lease treatment is desired, the IRS will look to the intent of the parties as expressed in the lease and in their actions. The typical “closed end” automobile lease is not a problem–it will usually be treated as a lease for tax purposes. Other equipment is more problematic. Some of the items to look at are the degree of risk assumed by the lesser and any bargain purchase option at the expiration of the lease.

In making the lease/purchase decision, there is no substitute for knowing the answer before you begin, so the deal can be structured to meet your business, economic, financial statement and tax goals. And like most tax related transactions, one must review the numbers, for often the result may be something different from what conventional wisdom may dictate. Even more important in this world of rapidly changing tax laws is to make sure the advice is still good in light of the tax laws in force at the time of the transaction.

The Internal Revenue Code is a dynamic and changing document, this article considers the law as it exists on December 31, 2010.

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